What are Interest-Only Mortgages and are They Worth It?

Interest-only mortgages are potentially useful tools that work well for some people in specific circumstances. But are they worth it?

Mortgages are an almost-inescapable part of buying a home.

Even anti-debt-crusading Dave Ramsey allows that buying a home with a mortgage is ok, though he insists borrowers should take the 15-year-fixed variety and pay extra against the principal to pay it off early.

Interest-only mortgages are almost the exact opposite of that strategy.

Can they ever be a good idea?

What Is an Interest-Only Mortgage and How Does It Work?

An interest-only mortgage is one where for an initial period (typically five, seven, or 10 years) you’re only required to pay interest.

Because you don’t have to pay anything toward the loan principal (i.e., to reduce the loan balance), monthly payments are lower during that initial phase than those of a conventional loan with the same interest rate.

As a result, your balance doesn’t decrease during the initial phase as it would with a regular mortgage, because payments for regular loans include a principal portion, initially very small but gradually growing, that can build equity.

After that initial phase, your loan gets amortized over the remaining term of the loan, or, in some cases, you need to pay off the loan (e.g., selling the property or refinancing the loan).

For example, say you get a 30-year, $650,000 jumbo mortgage with a 10-year interest-only period with a fixed 6-percent rate, followed by a 20-year amortized period with a then-market rate. Your monthly payment (P) during the initial phase (excluding insurance, taxes, and any homeowner association fees) would simply be one-twelfth the annual interest rate (R) applied to the full loan balance (B).

P = R × B / 12

or in our example:

P = 0.06 × $650,000 / 12 = $3250

This is almost 17 percent lower than the $3897 monthly principal and interest payment of a 30-year-fixed loan with the same initial balance and interest rate.

After the interest-only phase, if the remaining 20-year amortizing period has the same 6-percent fixed rate, your payments would jump to $4657. The payments here are much higher even with the same interest rate because you have to pay off the loan in full within the remaining 20 years, rather than the 30 years you would have had with a regular loan.

Note, however, that an interest-only mortgage may also have an adjustable interest rate that could adjust your payments (up or down) as often as monthly, or as infrequently as every five years. In most cases, the rate is capped at 2 percent higher than your initial interest rate.

However, even when capped like that, your payments could be vastly higher as a result. In our example, if your rate increases to the 8-percent cap (if the then-market rate is at least that high), your payments could soar to $5437 or 67 percent higher than your initial interest-only payments.

Also, while you’re not required to pay a single dollar toward principal during the interest-only phase, you’re not prevented from doing so, which would reduce the balance that gets amortized (and thus the monthly payments) once the interest-only period ends.

These loans may seem similar to adjustable-rate mortgages (ARMs), but interest-only loans don’t conform to government-sponsored enterprise (GSE) guidelines, so they can’t be sold to Fannie Mae or Freddie Mac.

That’s why most lenders only offer jumbo interest-only loans, so you need to have the income and credit score needed to qualify for the much higher amounts of jumbo mortgages.

Advantages of Interest-Only Mortgages

There’s no denying that interest-only loans have a great deal of appeal for borrowers.

This is especially true when mortgage rates go up as much and as rapidly as they have since the Fed started raising its rate earlier this year.

Such loans, as we saw above, can save you hundreds of dollars a month on your mortgage payments. Since the lender isn’t locking in the rate for 30 years, you may also find a lower rate for such a loan, reducing your payments even further.

As a result, you may be able to qualify for a larger loan that lets you buy a more expensive home. Especially given the real estate market’s meteoric rise during most of 2022, that can be very enticing. Next, since you’re not required to pay down your principal but are allowed to, a no-interest loan offers you greater flexibility.

Finally, if you do pay extra toward the principal, it will immediately reduce your remaining payments, because the interest (and the later amortization) will be calculated on a lower balance.

This is different from the effect of paying extra toward a regular fully amortized loan, where the balance doesn’t affect ongoing payments – it just lets you pay off the loan earlier.

In short, the advantages (during the interest-only phase) are:

• Lower monthly payments for a given loan size and interest rate, increasing your positive cashflow
• You may find a lower interest rate than a standard mortgage because it isn’t locked for 30 years
• Larger loan amounts are possible for a given payment amount
• Greater flexibility in how much (if any) you pay toward the loan principal
• Paying extra toward the principal immediately reduces your required monthly payments

Drawbacks and Risks of Interest-Only Mortgages

As always, nothing is purely advantageous. There are always drawbacks, and in some cases, as is true here, there are even risks.

One important drawback is that, as mentioned above, these non-conforming loans have more restrictive underwriting requirements (e.g., a larger down payment) that make them harder to qualify for.

Second, once you’re out of the interest-only phase, your interest rate may be higher. As shown above, this could increase your payment by over 67 percent (and in some cases could potentially double or triple your payments!). Further, even if your interest rate stays the same, your payments will still be much higher (more than 40 percent in the above example) for the remaining decades of the loan.

Third, and related to the above, if you keep the mortgage until it’s paid off in say 30 years, the interest-only loan will cost much more in total. In the above example of a $650,000 6-percent loan, even if it stays at 6 percent into the amortized period, you’ll pay a total of $1,507,632 whereas a 30-year-fixed 6-percent loan would total $1,402,948 - costing you $104,684 more.

Fourth, if you don’t pay anything toward the principal in the initial phase (because it isn’t required), your debt won’t go down at all for many years. As a result, if you don’t pay at least 20 percent down, and have to pay for private mortgage insurance (PMI), you’ll likely have to keep making those PMI payments for many more years, since you’re not reducing your loan balance for up to 10 years, so the only way your loan-to-value (LTV) can drop below 80 percent is if the market raises the value of your home by 25 percent.

The biggest risk you take on is that the higher payments after the interest-only phase increase your risk of defaulting and losing your home.

Another risk is that a market decline is more likely to drop the home’s value to less than you owe, putting you “underwater,” compared to a regular mortgage where you pay down the balance from Day 1. This could make it harder to sell your home or refinance because you can’t get enough to pay off the existing mortgage.

To summarize, the drawbacks and risks are:

• Restrictive underwriting makes it harder to qualify and may require a larger down payment
• Once the interest-only phase is over, payments grow significantly for the remaining decades, even if your interest rate stays the same
• If your interest rate adjusts higher, your payment could end up doubling or even tripling (especially if you started out at a low rate and it goes up to the cap)
• The total cost of the loan, if kept until it’s paid off, is much higher than a regular mortgage with the same interest rate
• Your balance owed doesn’t go down at all during the interest-only period, and you may be forced to pay PMI for many more years
• The far-higher payments after the interest-only period ends will increase your risk of default and losing your home; even if you can make those payments, they’ll dramatically hurt your cashflow
• A market decline could make it hard, if not impossible, to sell your home or refinance the loan

Are There Any Situations Where You Might Consider Getting an Interest-Only Mortgage?

While the risks and drawbacks of interest-only mortgages are very real and can be quite severe, there are several situations where they might be appropriate for you.

Here are some examples.

1. Your income fluctuates a lot, e.g., because you’re paid commissions or have highly seasonal income, so you need to keep required payments as low as possible, catching up when your income spikes
2. You expect your income to jump significantly soon (e.g., you have a high-paying job lined up after graduation)
3. You expect to get a large sum soon that will let you handle higher payments or even pay off the loan in full in the relatively near future; as Chris Kimmet, CFP®, MBA, Founder of Steady Climb Financial Planning says, “An interest-only loan could be a good fit for a client who expects to only have the loan for a short time and is awaiting a lump sum that they would use to pay off the principal soon. An example would be someone who’s in the process of selling another property, has an inheritance that is being processed, or another scenario where they are certain of receiving a large lump sum to cover the cost of the property.”
4. You expect to move before the interest-only period ends; Cecil Staton, CFP® CSLP®, President & Wealth Advisor at Arch Financial Planning, LLC gives an example of this, “Retirees looking to live in a home for a limited time could benefit from an interest-only mortgage. For example, a retiree who plans to downsize in 10 years, e.g., from a multi-story home to a single-floor condo or an assisted-living facility.” Michael R. Acosta, CFP®, ChFC®, Financial Planner at Consolidated Planning shares another example of this, “Interest-only mortgages could make sense for someone planning to flip the home quickly.” This last scenario may also work well for someone planning to renovate the property, lease it out for a few years, and then sell it for a tidy profit.
5. You don’t plan to keep the loan beyond the interest-only period, as Acosta says, “You may be planning to refinance the home to a lower rate once interest rates drop below the interest-only loan’s rate. Though somewhat risky, this strategy keeps mortgage payments as low as possible during what is typically a short time. The lower monthly payments allow you to set aside and invest more, building more liquidity you can use for, e.g., a lump-sum payment toward the mortgage if you decide to stay in the home longer than originally planned, a down payment on your next real estate investment, or just increasing your liquid savings. This isn’t a strategy for everyone, but it certainly has its time and a place.” This offers you a way of buying a pricier home without staying house-poor for many years.

In several of the above, you might ask why not put off the purchase until your higher income or your windfall materialize. The answer may be that you’ve found the home you want, in the area you want, and at a great price, but you have to pull the trigger now or the opportunity will disappear.

Where Can You Get an Interest-Only Mortgage?

Because these loans are non-conforming, lenders have a harder time finding investors willing to fund them. That’s why not all lenders offer interest-only mortgages. Still, many do. If an interest-only loan is right for you, you can look at:

• Your current financial institution
• Brick-and-mortar banks
• Online banks and lenders
• Credit unions
• Mortgage brokers

If you have trusted mortgage people, ask them. Even if the lender they work for doesn’t offer such a loan, they likely know lenders who do and who may offer good terms.

What Are Some Alternative Solutions That May Be Safer?

If none of the above five scenarios (where interest-only mortgages may be appropriate) apply to you, or if you’re simply uncomfortable taking on this level of risk, here are some alternatives to consider.

• Ideally, if you expect to get a windfall and/or higher income soon, put off buying a home until the extra money and/or income is in hand (long enough to satisfy underwriters)
• If you can’t afford the payments of a 30-year-fixed mortgage, consider buying a lower-cost home by buying a smaller home or one in a less-expensive area
• Look for programs that may help you buy the home you want with lower payments, e.g., first-time homebuyer programs
• If you’re looking for low payments for a set number of years but may not qualify for an interest-only loan, consider an ARM (but have a clear plan to avoid the potentially huge jump in monthly payments once the initial fixed-rate period is over)

The Bottom Line

Interest-only mortgages are potentially useful tools that work well for some people in very specific circumstances. 

However, they come with significant drawbacks and risks, so be sure you understand fully what you’re getting into. Research and understand all the terms and conditions, and plan what you’ll do should your payments jump as a result of keeping the loan beyond the interest-only period.

Note also that it’s too easy to get used to paying the lower interest-only payments, forgetting they will dramatically increase until that increase happens. This makes it harder to prioritize investing the excess cashflow rather than spending it.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.