Interest-Only Home Loans

Let’s take a moment to talk about interest-only home loans.  These days, very few individuals seem to be interested in actually paying off their mortgage. Many prospective and current homeowners alike just want to get the cheapest financing available, with the lowest payment options.

That’s usually means securing 100% financing on top of an interest-only option. And with so many exotic mortgage programs available, such as negative-amortization loans and programs with introductory teaser rates, it’s easy to understand why.

Interest-only options are almost standard on mortgages these days. They’re available on pretty much any program, from a 30-year fixed rate mortgage to a one month adjustable-rate mortgage. The pick-a-pay loans have an interest-only option available as well.

Do You Want to Pay Off Your Loan or Keep Payments Low?

But what many homeowners may not realize is that offsetting or reducing monthly mortgage payments increases the overall interest one pays over the life of the loan, and reduces the amount of home equity one will gain.

Let’s look at an interest-only home loan to highlight this point:

Loan amount: $500,000
Interest rate: 6.25%
Principal & interest payment: $3,078.59
Interest-only payment: $2,604.17

As you can see, the interest-only payment is much more attractive than the principal and interest payment, nearly $500 less each month.

If you make interest-only payments on your mortgage each month for the first ten years, you will pay substantially less than your fully-amortized payment, but gain nothing in the way of home equity.  Precious home equity…

So if you took out a mortgage with no money down, you would have zero ownership in your home unless it appreciated during that time. Meaning home prices must rise for you to gain any equity whatsoever.

Interest-Only Home Loans Eventually Adjust Higher

Here’s another important warning about interest-only home loans.  The interest-only period typically only lasts for the first 5-10 years of the loan, at which point your monthly mortgage payments can jump to possibly unmanageable levels.

You actually get hit twice.  After the interest-only periods ends, your minimum payment converts to the fully-amortized payment.  And because the entire mortgage balance could still be intact after only paying the interest due each month, you’d have to pay that balance in 20 years instead of 30 (assuming it’s a 30-year loan).

Hello significantly larger mortgage payment!  That is, unless you’re able to refinance or sell before that happens…which is what most people bank on.

Most homeowners usually just refinance once their options are reduced, and find a new, lower payment option. And then repeat the cycle. With home prices on the up and up, the idea is that you can eventually gain considerable ownership in your home without ever paying any money to the principal balance.

This was the main premise of the infamous option arm. But those days seem to be well behind us now.

You Pay for the Interest-Only Privilege

Interest-only loans usually come at a cost too, about .125 to .25 to the fee, or perhaps .125 (1/8) to the interest rate. So instead of an interest rate of 6.25%, you might be stuck with a rate of 6.375% if you opt for an interest-only option.  Or higher closing costs.

Put simply, you actually have to pay for the privilege to not pay down your principal balance, which seems a bit odd.

That being said, many think interest-only mortgages are a complete waste of time, and that you should always pay down at least some principal each month. But it really depends on what you plan to do with your home, and if you see yourself owning the property outright at some point.

If it’s just an investment property, or a short-term fixer upper, you could argue in favor of making interest-only payments to keep costs low while leveraging the money elsewhere. But if you plan on staying in your home long-term, it is wise to pay principal and interest to gain ownership in your home.

Benefits of interest-only mortgages

  • Smaller monthly mortgage payment
  • More affordable if money is tight
  • You can buy a bigger/more expensive home today
  • Excess cash each month can be used for other higher-yielding investments
  • Less money locked up in an illiquid asset
  • You can still build equity if home prices rise

Disadvantages of interest-only mortgages

  • None of the monthly payment goes toward principal
  • You typically must pay a cost or take on a higher interest rate for the IO option
  • You can land in an underwater position pretty easily
  • The interest-only period is temporary
  • You will need to refinance, sell, or make larger payments in the future
  • Harder to sell/refinance with little or no equity
  • Doesn’t really work without home price appreciation

17 Comments

  1. Tim Talman August 16, 2014 at 10:21 pm -

    Thanks for your article Colin. Boy do I wish I knew how to get my family out of the underwater, interest only, bank held property we are now carrying around like an anchor! We desperately want to get out and buy a new modestly bigger property, but are held down by our current situation.
    TT

  2. Rob Auerbach December 15, 2015 at 7:40 pm -

    We currently have a interest only loan we took out 10 years ago. It still has another two years to go on it. Our current total loan is $275,000.00. Houses in our neighborhood have gone up and we figure our house is worth about $400,000.00. My wife and I are over 60 and we know we will never pay our house off and we don’t care. We have had our home for 26 years. Since we will have some addition equity we thought another interest only loan would be good for us as we are both retired. Should we take equity out when we refinance for home updates (which we could use) or leave it in which seems like a waste to us. We like the idea of lower monthly payments. A big factor is our lack of knowledge in any type of home financing. One broker told us interest only loans are hard to get and we may need mortgage insurance. We have never had to pay insurance before so it’s a bit confusing. Would you be willing to point us in the right direction?

    Thank you for any help you might share with us!

    Rob and Colleen

  3. Colin Robertson December 16, 2015 at 1:06 pm -

    Rob,

    Interest-only loans are a lot harder to get nowadays and you’ll pay more to get one because of the Qualified Mortgage rule, which outlawed them. Pulling out equity is your decision as is going with an IO loan vs. a fully amortizing one. If you never want to pay back the loan that’s your call. You won’t need mortgage insurance unless you borrow more than 80% of the home’s current value in a single loan.

  4. Big B January 11, 2016 at 3:08 pm -

    We have a situation:
    1.0 House bought $220k, in 2005. It is now worth $180k,
    2.0 Financed $220 K, $175 now fixed, but $45k is IO.
    3.0 10 yrs. are up for IO and payment jumped from $125/mo. to $825/mo.

    What the heck should I do?

  5. Colin Robertson January 11, 2016 at 3:24 pm -

    Big B,

    This is exactly why interest-only loans have been given the boot. Traditionally, most folks in your situation would refinance into a new loan…but obviously you may have difficulty finding a solution seeing that you’re underwater. Options may include a cash-in refinance to get the LTV down or some kind of loan modification to reduce the rate and possibly extend the term to get payments down.

  6. Mary May 22, 2016 at 7:05 am -

    I have a regular home loan mortgage of $208,000 with 4% interest and a second interest only mortgage of $26,000 (interest only for 5 years, then payments with a fixed 4%) Which account will I be better served by sending extra principal payments? Would it be better to send all extra money to pay off the interest only account

  7. Colin Robertson May 23, 2016 at 8:29 am -

    Mary,

    Since they are both set at the same rate, 4%, and you have a larger balance on the $208k first mortgage, you’re paying more interest each month and would reduce the outstanding balance a lot faster making extra payments on it. Conversely, some folks recommend paying off smaller balances first so you can completely eliminate them and get a short-term “win.” But that’s a psychological thing that may not apply to everyone. Also consider what happens to the interest-only loan once it becomes fully amortizing, including what the monthly payment will rise to and what the remaining term will be (e.g. 25 years, 20 years, etc.).

  8. Linda October 6, 2016 at 1:03 pm -

    We are in our 70s and owe $550,000 on our townhome which is currently appraised at $800,000. We are interested in a 40 year refi with interest only for the first 10 years.
    Our current rate is 4.25%. Any advise is appreciated.

  9. Colin Robertson October 11, 2016 at 8:04 am -

    Linda,

    Some lenders offer that option…I think Union Bank has 40-year IO.

  10. Asad October 20, 2016 at 12:13 pm -

    Hi Linda,

    Came across your post, feel free to email me if you’d like to discuss our 40 Year I/O and qualifying criteria.

  11. Dean Pittman December 23, 2016 at 7:27 pm -

    I asked my commercial loan banker if they had interest only loans and he acted like he didn’t know what I was talking about.I asked him whats the best loan he could get me on a 675 k loan and and he said 165 k down and finance,500 k with 4-5 k payments a month on a 20 year and it’s income producing property,3 k,and possibly 4 k monthly income in a high traffic appreciating area..I get a feeling they are saving this for their other investors of the bank and just trying to scare me off wanting it..gettin a feeling there’s a monopoly going on here..Anybody else out there reading this do me any better…
    D P

  12. Kenneth February 17, 2017 at 9:11 am -

    My wife and I are looking at buying a new home. We have a lot of equity in our current home and will sell that to make a sizeable down payment. We also have a rental property in our back pocket that has equity and we think we can sell down the line. My thought was to buy our new home with an IO loan, but make what equates to a 30 fixed payment each month, thus paying down principal and paying less interest over the life of the loan. Yes we plan to pay off the new house and live there into retirement. When the IO time period is up, I’d either look to refi into another loan option or sell the rental property to pay off the loan. What are your thoughts on this strategy?

  13. Colin Robertson February 17, 2017 at 10:27 am -

    Kenneth,

    Is the IO loan going to be cheaper than a 30-year fixed? Otherwise what’s the point of adding an IO option that you often have to pay extra for when you’re not going to use it?

  14. Mimi February 19, 2017 at 3:04 am -

    Our situation is complicated. We have an IO loan that just matured. Our mortgage payment went from $2200 to $4000. Our loan is for $505K, our house is worth approximately $870K. We are worried we won’t be able to refinance because we are self-employed and our tax returns don’t show enough income, and we have a large loan on an investment property (we owe $447K, and it is worth approximately $660K, and we make about $700/month in rents). We also have a $40K line of equity we used to buy a business. No other debt in terms of credit cards, cars, etc. We make around $90-100K, but our tax returns show much less (not sure exact amount). We haven’t filed 2016 yet (we always get an extension) and have a little wiggle room with how many write offs we want to submit. I have spent the day filling out modification paperwork, and we have started talking to lenders to refinance. Do you think we will be able to do one or the other? What is our best course of action? I cannot believe we have been in our house for 12 years and haven’t paid down any principal. The IO loan was supposed to be temporary, but then the recession hit, and then we had circumstances where we could never qualify for a better loan. Oh ya, we have a foreclosure from 4 years ago on an investment property that went bad during the housing crash. Would appreciate any advice you have!

  15. Colin Robertson February 20, 2017 at 4:13 pm -

    Mimi,

    It sounds like you have lots of equity, despite paying no principal…maybe an LTV around 63% if outstanding loans are $545k based on $870k value. That’s a plus because it’s so low. The negatives are the foreclosure, your potential income issue, and the fact that it might be treated as a cash out refi because of the line of credit. May want to speak with some brokers/lenders to run the numbers and see what you qualify for and if that foreclosure will be an issue.

  16. Jared May 30, 2017 at 8:20 am -

    I have a a 10 IO/30 yr mortgage that recently “reset”, paying an additional $1K/mo, I have 6.25% rate right now and was thinking of refinancing it. My question is, what will happen if I refinance, will it get recalculated lowering my payoff amount due the interest that I already paid? ex. The original loan is $472K, and I’ve been paying $2500 IO for 10yrs, now paying $3500 Interest + principal for 1yr, making my outstanding loan ~$460K, will my payoff amount be lower than that? Thank you for your advice.

  17. Colin Robertson May 30, 2017 at 2:25 pm -

    Jared,

    Interest paid doesn’t affect an outstanding principal balance. As you mentioned, your loan balance is around $460k now, reflecting about one year of principal AND interest payments based on a 20-year term (time remaining from 30 years). All the interest-only payments before that time didn’t go toward your principal balance, hence why it’s referred to as IO. Your loan servicer should be able to provide you with a payoff statement, or you might be able to log-on to their website to see your current balance, which should be close to the payoff amount if/when you refinance.

Leave A Response