What You Should Know about Interest Only Mortgages

Many consumers are not familiar with the concept of an interest only mortgage.  Once a fairly common approach to home financing, this loan type does provide some significant benefits to qualified homeowners as well as some potential liabilities. Below is plenty of interest only mortgage FAQs as well as varied information and ideas on when this loan strategy may be right for you as well as what you should know about interest only mortgages.

Everything You Need To Know About Interest Only Mortgages

If you are looking to buy a house, then you have probably come across the term ‘interest-only mortgage.’ An interest-only mortgage is a loan where you pay the interest for a specific time. It means lower monthly payments, even a faster pay-off period. However, interest-only mortgages do not have equity. It comes with higher interest rates as well.

So is an interest-only mortgage suitable for your situation? Before you apply for one, make sure to read all the facts below first.

How Does Interest-Only Work on a Mortgage? 

The structure of this type of mortgage option is very straightforward. Like other mortgages, an interest only loan calls for retiring the debt over a specified period of time. What is different is that for a set term on the front end of that financing period, the debtor only pays the interest assessed on the loan. During that term, the interest rate applied to the balance is usually fixed.

For example, if you take out a 30-year mortgage with an interest only term of 10 years, those 10 year mortgage rates will not change. Depending on the other terms and conditions of the loan arrangement, the interest rate could change to a floating or variable rate, or simply switch to another fixed rate.

An interest-only mortgage is a type of non-qualified loan. As the name suggests, you only need to pay the ‘teaser’ interest rate for a specific term. You are not required to pay the principal amount during this term, but you may do so. Once you pay the interest-only amount, your mortgage will go back to full amortization. This schedule runs from 20-30 years.

As with the conventional mortgage, you now have to pay the interest and principal after the term. More often than not, the interest rate is often higher than the previous ‘teaser’ rate. As for the principal amount, it will be computed according to the remaining period.

In the past, borrowers could make a balloon payment after the mortgage. It involves paying the total principal amount by the end of the term. However, the law no longer permits this type of payment.

Adjustable-Rate vs. Fixed-Rate

Interest-only mortgages come in two forms: adjustable and fixed-rate.

Adjustable – As the name suggests, the interest rate here varies. It can be risky since you can’t predict the rate you’ll get after the interest-only period. This rate, of course, will depend on the market. As such, it will help to learn more about the interest rate floor, cap, and maximum before you get this type of loan. These factors should give you a preview of the prices you’ll pay in the future.

Fixed-Rate – Compared to the example above, the rate you’ll get with this mortgage is fixed. Although this is the case, you’ll still pay a considerable sum. For a 30-year loan, for example, you will only need to pay the interest for the first ten. As for the next 20, you need to pay both the interest and principal. Expectedly, you will need to pay a larger amount in the next 20 years. That is because the new interest rate will depend on the entire loan amount.

So for a $100,000 mortgage with a 3.5% interest, you will need to pay almost $580 for the next 20 years.  It is a far cry from the amount you have paid in the first ten years: $292. Then there is the issue of availability. Lenders do not usually offer a fixed-rate loan compared to adjustable-rate mortgages.

Why Would You Get an Interest-Only Loan?

Anybody can try to apply for an interest-only mortgage. That said, it is a better fit for the following borrowers:

  • You do not intend to hold the mortgage beyond the introductory period.
  • You can only handle low payments for a specific time (e.g., you’re still waiting to sell your home.)
  • You are selling your home BUT looking for an alternative to a bridge loan.
  • You buy houses to let/rent out.
  • You do not care much about building home equity.
  • You have a big loan where paying a small loan interest is very minimal.

In some cases, lenders will allow an interest-only mortgage due to home damage. After all, the borrower will need to pay a considerable amount for maintenance works. The interest-only run is limited – up until the borrower is out of the woods.

How Long Can You Have An Interest-Only Loan?

Borrowers may pay the interest for a term of three to ten years. It is what lenders refer to as the loan structure. Common examples include 3/1, 5/1, with the most popular being 7/1 or 10/1. The first number represents the number of years when you pay the interest. The second number is the interest adjustment. For example, for a 10/1 loan, you will need to pay the interest amount for a decade.

As for the interest rate, the adjustment is made once a year. It follows a specific benchmark, such as the London Interbank Offered Rate. Benchmarks fluctuate according to the market. That said, the lender will determine yours once when you get the loan.

Even with the market fluctuations, the rate cap follows a ceiling of 2% (for 3/1 and 5/1 loans) to 5% (for 7/1 and 10/1 loans.). So if you get a starting interest of 3% for your 3/1 loan, it can only increase to a maximum of 5%. As for a 10/1 loan, you may start at 3% interest, progress to 5% and 7%, and cap off with a maximum of 8%.

What Happens at the End of Interest-Only Mortgage? 

Once you finish your interest-only loan, you can:

Refinance Your Loan

Many people take another mortgage – repayment or interest-only – to pay off the balance. Again, you will need to apply for a loan once again to get your home refinanced.

Sell Your Mortgaged Home 

In fact, many homeowners do so and use the money to pay the principal amount. This technique can be pretty risky, though. If you’re lucky, your home’s selling amount may be more than enough to cover your balance. But if you’re not, you will need to come up with a significant amount for the shortfall.

Pay for the Principal Amount

If you have enough ‘savings’ from not paying the principal, you can use this to pay the remainder of your loan.

What are the Pros and Cons of an Interest-Only Loan?

As with any other type of loan, there are pros and cons to getting an interest-only loan:

Pros of Getting an Interest-Only Loan

Lower Monthly Payments in the First Few Years – Since you only need to pay the interest – not the principal – you do not have to spend much on payments. This loan allows you to save more for your future installments. Likewise, you can use this money to pay for utilities, credit card debt, etc.

Less-Rigid Requirements – Lenders can not sell interest-only mortgages to Fannie or Freddie. Their requirements for interest-only applicants are a bit looser. That said, the screening process remains the same. You will need to submit your credit score and debt-to-income ratio. The lender may require several other mortgage documents as well.

Favorable to First-Time Home Buyers – Most first-time homebuyers are young. That means they may not have the resources to pay the traditional loan. By getting an interest-only loan, they may defer the payment up until they’re earning more. By that time, they are more financially capable of paying both the principal and the interest.

Beneficial For Short-Term Homeowners – Do you want to own your home for a short time (less than ten years)? Then an interest-only mortgage is a worthwhile option. You can use the proceeds of the sale to pay the rest of your loan.

Allows You to Get a More Expensive Home – If you take an interest-only mortgage, you may buy a more expensive home. That’s because you only need to pay a lower amount for the first few years.

Faster Pay-off Period Compared to Conventional Loans – A conventional mortgage takes about 30 years. But with an interest-only loan, you may pay your home off faster. With the savings you’ve made throughout the years, you can make bigger monthly payments.

Cons of Getting an Interest-Only Loan 

No Equity – With an interest-only mortgage, you won’t get equity for your home. So if you sell it, you woll not get anything. Remember: you can only get equity IF you pay the principal amount.

Hard to Find – Interest-only mortgages are not as available as, say, the conventional loan. They are often only granted to people with a solid financial standing. You may qualify for one, but finding a lender who offers such is another issue.

Higher Interest than the Conventional Loan – Yes, you only have to pay a lower interest amount for several years. But in the long run, you will end up paying more in interest. That’s because the rate of an interest-only mortgage is 0.125% to 0.375% higher than a conventional one.

Risk for Default – Most people take interest-only loans thinking that they’ll earn more in the future. As always, there’s a possibility that this may not fall through. Likewise, job loss, hospitalization, etc., may drain your finances. Due to these unforeseen events, you may end up defaulting on your mortgage.

Housing Prices May Fall – In 2006, many homeowners ended up with mortgages that were pricier than their homes. Even if they sold their property, they still can’t afford the payments – so many of them ended up defaulting. In fact, many of these homeowners were interest-only borrowers.

Should this happen again, those who have interest-only loans may end up with the same fate. Such is the case if you are planning on selling your home at the end of the interest-only term.

Can You Extend the Term of an Interest-Only Mortgage?

Yes, but this entirely depends on the lender. In some cases, borrowers who can not pay – but refuse to sell their home – may get an extension while they switch to repayment. The problem with this, however, is you will end up paying a lot more. Apart from paying the interest, you will need to pay the capital amount as well.

Picture this: you have a 25-year, $125,000 interest-only mortgage that’s about to mature. From paying $313 a month, you will now have to pay $1,208 a month according to a 3% interest.

Can I Change to Interest-Only Mortgage?

Yes. Many lenders will allow you to shift from a repayment mortgage to an interest-only one. That said, you will need to pay an early repayment charge if you’re still in the introductory period. Right before the lender proceeds with the change, they will check for the following:

Your Repayment Strategy

How do you plan on paying the lender? Will you be following a buy-to-let strategy? Or will you sell the house once the mortgage ends? Remember, different lenders have different criteria. As such, your repayment plan must be feasible and realistic.

Credit History

Your lender will recheck your credit history – even if they have done so before. They want to know if you’re still managing your money well, if you’re paying your other loans, etc.

For one, an interest-only mortgage is riskier on their part. With repayment, borrowers need to settle the monthly amounts right away. But with an interest-only mortgage, lenders have to wait a few years before the client pays up.

How Long Do Lenders Want to See a Positive Credit History?

Lenders will look at the last six years of your credit history. As such, it is best to have a positive record within that period. Even if your credit history has some stains, what’s important is your attempt at clearing it. Making payments on time after delayed ones, for one, is something that lenders want to see.

Equity

The lender will also examine your home equity – how much of the property you own outright. Equity is reflective of the loan-to-value ratio – what you own vs. what you still owe.  If you don’t have much, then there’s a good chance that you might be denied.

Typically, you can borrow 95% of your home’s amount with a repayment mortgage. As for the interest-only loan, however, you will not get an amount this high.

Who Qualifies for This Type of Mortgage?

Qualifying for an interest only mortgage ranges from easy to difficult, depending on the lender. This is because lenders are assuming a little more risk on the front end of the loan, especially in areas where the market value of real estate is not particularly stable. Lenders will usually require that applicants have a steady job with an income that is in line with other debts they are currently managing.

In addition, lenders will look closely at credit reports to determine if there are any indications of possible over-extension based on current credit lines. For someone who has a stable job, a clean credit report and is not carrying a lot of unsecured debt, there is a good chance of being approved.

Why Would I Want an Interest Only Mortgage?

One of the chief benefits of this type of mortgage is the ability to enjoy lower monthly mortgage payments during that interest only term. For first time home buyers who are just getting established in their careers, this means the chance to put keep expenses lower for now, and take on the larger mortgage payment after they are earning higher incomes.

One strategy that is commonly employed is to refinance the remaining balance once the interest only term expires. This can make it possible to lock in a more competitive rate, presuming that the owner has built up a solid credit rating over the years and is considered a good risk by other lenders.

What About Drawbacks to this Type of Mortgage?

Interest only mortgages are not a good fit for everyone. Serious issues can arise if you have reason to believe the value of your property will decline over time. In like manner, this arrangement can be very difficult if you should lose your job and not find new employment in a short period of time.

Another drawback is the fact that homeowners don’t built equity during the interest only term. This can mean considerably less profit if you decide to sell the house before that term is fulfilled.

Are Interest Only Mortgages Hard to Find?

Not all lenders provide mortgages of this type. There are a number of mortgage companies that offer interest only loans, as well as a few banks and finance companies. A good place to begin the search for this type of mortgage arrangement is with your local banker. If the institution does not offer this particular option, the banker may be able to identify another institution that does. You can also conduct online searches to find reputable lenders in your area.

Bottom Line

Interest-only loans can be good or bad depending on your rationale for wanting one. They can be good options for those who need to pay a low amount for a few years or even first time buyers who are still building work equity.

However, they are not for everyone, especially those who do not want their mortgage to increase in the future or who are most interested in building equity in their home.

Given these pros and cons, only you (and a lender) can determine if interest-only mortgages are a good fit for your specific needs.

About Anita Clark Realtor

Anita Clark has written 612 posts on this blog.

Anita is a residential Real Estate Agent in Warner Robins Georgia, with Coldwell Banker Access Realty (478) 953-8595, aiding buyers and sellers with all their real estate questions on her Warner Robins blog.