How Does An Interest-Only Mortgage Work?
An interest-only mortgage is a home loan with a unique perk: For a few years, you can make very low payments that only cover interest. Following that period, you can either refinance, pay the remaining balance in a lump sum or begin making regular monthly payments.
Having low monthly payments for the first several years you own your home can be a big relief, but there are also many drawbacks and risks that come along with interest-only mortgages. Read on to learn about interest-only mortgages, how you can qualify for one and more.
What is an interest-only mortgage?
An interest-only mortgage is a home loan that has very low payments for the first several years that only cover the interest owed — not the principal. These lower initial payments may last for as long as 10 years, but after that you’re required to start making payments toward the principal balance.
Interest-only mortgages are nonqualified mortgage (non-QM) loans, which means they come with features that the Consumer Financial Protection Bureau (CFPB) considers potentially risky. These include the interest-only period itself as well as, in some cases, a balloon payment. For this reason, interest-only loans don’t qualify for government-backed programs, like FHA, VA or USDA loans.
Why would anyone want an interest-only mortgage?
Someone who wants to put their cash to work elsewhere in the short term — often another investment opportunity — may want an interest-only mortgage. Or, maybe a borrower is expecting a windfall, bonus or another income boost before the interest-only period ends.
Many borrowers also plan to sell or refinance after a short period of time, which allows them to get out of the mortgage before it ever requires them to make those larger principal-and-interest payments.
As long as the home’s value appreciates, it’s possible to buy a home with an interest-only mortgage and sell it before any principal payments are due — all while earning a profit.
How an interest-only mortgage works
There are two different periods that make up the borrowing term for an interest-only mortgage loan.
Initial periodDuring this time (which typically lasts three to 10 years), you’ll only make payments on the mortgage’s interest. Your payments won’t reduce the principal balance or build equity in your home. (However, you may still build equity if your home’s value rises over that time period.)
Repayment periodWhen the initial period ends, the loan will convert to an amortization schedule. You’ll make larger payments that go toward both the principal and interest for the remainder of the loan term. Alternatively, you may have a balloon payment due at this time.
An interest-only mortgage’s interest rate is the final key piece of the puzzle. Most interest-only mortgages are adjustable-rate mortgages (ARMs), which means your interest rate will adjust over time with the market. Because of this, you likely won’t have predictable, fixed monthly payments. In some cases, your rate and payments will stay the same but only during the interest-only period.
Interest-only mortgage example
The table below shows how much you might pay in interest if you took out a $300,000 home loan with a 10-year interest-only period, versus a traditional, fully amortizing mortgage.
| Loan type | Interest rate | Initial monthly payment | Amortized monthly payment | Total interest paid |
|---|---|---|---|---|
| 10-Year Interest-Only Mortgage | 7.22% | $1,805.00 | $2,365.68 | $484,361.97 |
| Conventional Mortgage | 7.22% | $2,040.43 | $2,040.43 | $434,554.06 |
This example shows that, at today’s rates, you’d pay about $49,800 more in interest over the life of your loan if you choose an interest-only loan over a conventional mortgage, unless you make more than the minimum payments during the initial phase.
Interest-only mortgage rates
The rates on interest-only loans tend to be a bit higher than 30-year conventional mortgage rates. Just keep in mind that the longer your interest-only period, usually the higher your interest rate will be.
In addition, once your interest-only mortgage rate begins to adjust, it’ll fluctuate with the broader market. The current mortgage interest rates forecast is for rates to gradually drop over the remainder of this year — but where the market will stand in five, seven or 10 years, no one knows. That’s why your best bet with an ARM is to make sure you can afford the payments even if the rate adjusts up to its maximum.
Learn more about how ARM rates work, including their rate adjustment caps.
How to qualify for an interest-only mortgage
You may think that a mortgage with lower initial monthly payments would be easier to qualify for, but that’s not necessarily true. In fact, many lenders may have even more stringent requirements for their interest-only loans than they do with standard, fixed-rate loans.
To qualify for an interest-only mortgage loan, you’ll likely need:
- A credit score above 700
- A debt-to-income (DTI) ratio below 36%
- A down payment of at least 15% (depending on the lender)
- Enough income and assets to demonstrate that you can repay the loan
That said, because interest-only loans are non-QM, they can use a wider variety of means to demonstrate your ability to repay. Some lenders may use traditional methods — like pay stubs or tax documents — to calculate your income. But others might accept alternative means, like bank statements or proof of other assets.
Don’t know your credit score? Get your free score on LendingTree Spring today.Pros and cons of interest-only mortgages
| Pros | Cons |
|---|---|
Low initial monthly payments. Your monthly payment will be lower than a comparable conventional mortgage for the first several years of repayment. Frees up your cash. With a lower monthly payment, you’ll have more cash on hand to invest or put toward other financial goals. Tax benefits. Since you can deduct mortgage interest on your tax return, an interest-only mortgage could result in significant tax savings during the interest-only payment phase. | Payments will increase. Once the interest-only period ends, your payments will go up. You’ll pay more interest. Though your initial payment will be smaller, the total interest paid will be higher than with a traditional mortgage. More stringent requirements. The down payment and credit score requirements are typically harder to meet, compared with traditional mortgage requirements. Delay in building equity: You won’t build equity in your home unless you make extra payments toward the principal during the interest-only period. Refinancing isn't guaranteed. If your home loses value, it could deplete the equity you had from your down payment and make refinancing a challenge. |
Should I get an interest-only mortgage?
You should consider an interest-only loan if …
→ You’re planning to live in the home for a short time: If you’re planning to sell the home before the interest-only period is up, an interest-only mortgage could make sense — especially if home values are appreciating in your area.
→ You can afford the payments but want better cash flow: If you can recoup the extra interest you’d pay on an interest-only mortgage with another investment opportunity, having the flexibility of lower payments could help you grow your money.
→ You’ll be coming into more money by amortization time: If you’ll have access to a retirement account or an inheritance by the time the interest-only period ends, an interest-only mortgage can help you avoid waiting to buy.
You shouldn’t consider an interest-only loan if …
→ You can’t afford the full monthly payment: Eventually, you’ll have to make principal and interest payments. Don’t assume you’ll earn enough income at that time to cover the higher payments. Budget for repayment based on known quantities, like the income you earn today and any funds you know you’ll have access to later.
→ You need down payment assistance: If you can’t afford at least a 15% down payment, you’ll need to consider another loan type.
→ You want the most cost-effective mortgage: An interest-only loan is going to be more expensive to finance than a qualified mortgage. If your primary concern is minimizing your overall loan costs, an interest-only mortgage isn’t for you.
Interest-only mortgage alternatives
Hybrid mortgages
If an interest-only loan isn’t a good fit, one alternative is a hybrid adjustable-rate mortgage like a 5/1 ARM loan. Hybrid loans can come with lower rates than fixed-rate loans, yet still have a fixed rate for the initial term. In some cases, they can provide a lower monthly payment than a 30-year fixed-rate, fully amortized loan for those initial years — typically five, seven or 10 years.
The big drawback of a hybrid mortgage is that once the interest rate converts to an adjustable rate, your payments can skyrocket. If you haven’t chosen your loan carefully, your payments could become unaffordable.
See current ARM loan rates and top lenders today.Conventional fixed-rate mortgages
If unpredictable payments sound stressful, or if you want to save money over the life of your home loan, a conventional fixed-rate mortgage is a good alternative. When you apply for a conventional fixed-rate mortgage, you’ll lock in your interest rate and your monthly payments will remain the same over the loan term.
Conventional fixed-rate mortgages typically come in 15- or 30-year terms. Historically, their rates tend to be higher than adjustable rate mortgages. The average interest rates on these two loan types have become much closer, however. Today, there’s no guarantee that an ARM will come with a lower rate than a fixed-rate mortgage.
See competitive mortgage rates today.Government-backed home loans
FHA loans
If you don’t have enough saved for the down payment on a conventional mortgage, or if you can’t qualify for one due to a low credit score, an FHA loan may be a good option. These loans are backed by the Federal Housing Administration (FHA), which allows them to come with more flexible requirements. However, all FHA loan borrowers will need to pay two types of FHA mortgage insurance, which can drive up their overall loan costs.
You can qualify for an FHA loan with a credit score as low as 500, as long as you can afford at least a 10% down payment. However, you have the option to put down only 3.5%, though you’ll only qualify if you have a minimum 580 credit score.
See current FHA mortgage rates today.VA loans
If you’ve served in the military, you may qualify for a VA loan backed by the U.S. Department of Veterans Affairs (VA). Most VA loan borrowers don’t have to put any money down and can enjoy very competitive interest rates, no mortgage insurance and easy refinancing with a VA streamline refinance (VA IRRRL). There’s no minimum credit score requirement, though many lenders won’t go below 620.
See competitive VA mortgage rates today.USDA loans
Borrowers who live in designated rural areas may qualify for a USDA loan backed by the U.S. Department of Agriculture (USDA) to buy, build or improve a house. You’ll typically need at least a 640 credit score to qualify, though each lender is free to set their own minimum. To find out whether the home or area you’re interested in is eligible, use the USDA loan map.