Let’s take a moment to talk about “interest-only mortgages.” A decade ago, very few individuals seemed to be interested in actually paying off their mortgages.
Many prospective and existing homeowners alike just wanted to get the cheapest financing available, with the lowest monthly payment options, regardless of the consequences.
That meant buying real estate with 100% financing and throwing in an interest-only option on top. Oh, and these loans were typically adjustable-rate mortgages, not 30-year fixed mortgages.
And the once very popular pick-a-pay loan had an interest-only option available as well.
Jump to interest-only loan topics:
– How Does an Interest-Only Mortgage Work?
– Pay Off Your Loan or Keep Payments Low
– Interest-Only Home Loans Eventually Adjust Higher
– You Pay for the Interest-Only Privilege
– How to Calculate an Interest-Only Mortgage
– Interest-Only Mortgage Qualification
– Can You Still Get an Interest-Only Mortgage?
– Pros and Cons of Interest-Only Mortgages
With so many exotic mortgage programs available, such as negative-amortization loans and loan programs with introductory teaser rates, it was easy to understand why borrowers did what they did.
In fact, interest-only options used to be almost a given on mortgages back then. But we all know how things turned out.
We experienced the worst housing crisis in modern history, driven largely by loose mortgage lending.
Fortunately, times have changed, and these days it’s pretty uncommon to find a mortgage lender willing to give you an exotic loan, including an interest-only mortgage.
How Does an Interest-Only Mortgage Work?
- You get the option to pay only the interest due each month
- None of your monthly payment goes toward the principal balance
- This means the loan amount doesn’t decrease with the payments
- But you can still make fully-amortized payments if you want
In a nutshell, an interest-only mortgage gives you the option to pay just the interest portion of the mortgage payment each month.
This allows a homeowner to save money and still gain equity if home prices increase, even though their loan balance stays the same.
A standard mortgage payment consists of two main components: principal and interest.
The principal portion is the amount you owe (the loan amount), and the interest portion is the cost of financing what you owe. The bank isn’t lending you money for free you know.
Instead of paying principal and interest, you just pay interest each month. And that makes it significantly cheaper.
Let’s look at an interest-only home loan to highlight this point:
Loan amount: $400,000
Mortgage rate: 6%
Principal & interest payment: $2,398.20
Interest-only payment: $2,000.00
Imagine a $400,000 loan amount with a 6% mortgage rate. And pretend it’s a 30-year fixed-rate loan.
As you can see, the interest-only payment is much more attractive than the principal and interest payment, nearly $400 less each month. That’s the appeal.
Note: You still have the option of making the fully-amortized payment (principal and interest) if you choose.
Do You Want to Pay Off Your Loan or Keep Payments Low?
- An interest-only mortgage is good for keeping payments low
- Can be helpful if you have limited cash flow or uneven income
- The downside is you won’t actually be paying down the loan
- Eventually you’ll need to unless home prices rise and you sell it
The main advantage of an interest-only mortgage is the lower monthly payment.
But the tradeoff is you pay more interest over the life of the loan.
If you make interest-only payments on your mortgage each month for the first ten years, you will pay substantially less than the fully-amortized payment, but gain nothing in the way of 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.
If home values happened to fall during that time, you could easily find yourself in an underwater position with nothing put down and no principal paid.
The Main Disadvantage of an Interest-Only Loan: They Eventually Adjust Higher
- The interest-only period typically ends after 10 years
- Then you must make fully amortized mortgage payments
- Over a 20 year period (remaining loan term if 30 years)
- This can result in a very significant payment increase
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 (principal and interest payments).
And because the beginning mortgage balance could still be fully intact after only paying the interest due each month, you’d have to pay that full loan balance in 20 years instead of 30 (assuming it’s a 30-year loan).
Hello significantly larger mortgage payment! If it’s an ARM, you could get hit three times if the interest rate also adjusts higher.
That is, unless you’re able to refinance your mortgage or sell the property before that happens…which is what most people seem to bank on.
But you can’t always count on lower mortgage rates in the future, and if you can’t handle the larger payment amount, beware!
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 toward the principal balance.
You Pay for the Privilege of an Interest-Only Payment
- The interest-only option typically isn’t a free add-on
- Expect either a higher mortgage rate for the option
- Or higher closing costs thanks to a pricing adjustment
- And some banks may require that you park your deposits in their low-yielding accounts
Interest-only loans usually come at a cost, maybe 0.25 to the fee, or perhaps .125 (1/8) to the interest rate.
So instead of an mortgage rate of 6.5%, you might be stuck with a rate of 6.625% if you opt for an interest-only option.
Or you may need to pay higher closing costs to the lender. On a $500,000 loan amount, this could be another $1,250 in fees.
Simply put, you pay for the privilege to not pay down your principal balance, which sounds a bit odd.
At this point you might 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.
How to Calculate an Interest-Only Mortgage
- It’s actually very easy to calculate since we don’t have to factor in principal
- Simply multiply the loan amount by the interest rate
- Then divide by 12 (months) to get the monthly cost
- And voila, you’ve got your interest-only payment!
This is probably one the easier mortgage calculations out there. Seriously, you don’t even need a mortgage calculator (or an interest only mortgage calculator for that matter).
All you have to do is take the interest rate, multiply it by the loan amount, and then divide that by 12 (months).
So if the mortgage rate is 4% and the loan amount is $400,000, simply input .04 and multiply it by $400,000.
That equates to $16,000, which is the annual amount of interest paid. Then divide by 12 and you get $1,333.33, which is the monthly interest-only mortgage payment.
And because the loan balance doesn’t change (go down) if you’re only making interest payments, the calculation never changes either. Easy!
Just note that there might be taxes and insurance paid monthly as well, if you have a mortgage impound account.
Interest-Only Mortgage Qualification
- In the past lenders may have used the interest-only payment for qualifying purposes
- But that was clearly flawed seeing that the payment wasn’t fully-amortizing
- Today expect to be underwritten with the principal and interest payment
- This ensures you can manage regular payments once the IO option disappears
Back in the day, it may have been easy for home buyers to qualify for an interest-only loan. Why? Because you could use the interest-only payment. Not anymore.
Lenders wised up and realized they couldn’t qualify someone using the lowest payment possible and ignore the higher payment looming on the horizon.
Thus, they tend to qualify borrowers at the fully-amortized payment or even higher. In fact, despite the 30-year loan term, qualification is often based upon a 20-year amortizing payment!
If it’s an adjustable-rate mortgage, which is a common combination with IO loans, it could be the higher of the start rate +2% or the fully-indexed rate.
For example, if your 7/1 ARM has an interest-only option and a start rate of 5.75%, you’ll need to qualify at a rate of 7.75% or even higher, depending on the fully-indexed rate.
Additionally, the lender may use a monthly payment based on a 20-year amortization, which would be the remaining period after the typical 10-year IO period.
Imagine the loan amount is $400,000 and the start rate is 5.75%. That would equate to an interest-only payment of $1,916.67.
Now if we pretend the fully-indexed rate is 7%, the qualifying, fully-amortized payment would be a much higher $3,101.20 based on a 20-year term.
It just got a lot harder to qualify for the mortgage because that monthly payment will push your DTI ratio up a lot higher.
Can You Still Get an Interest-Only Mortgage?
Lastly, note that interest-only options are only available on certain types of mortgages these days.
They were easy to obtain in the early 2000s, but are mostly outlawed due to the Qualified Mortgage (QM) rule, which doesn’t permit an interest-only period.
This means you won’t be able to get one on a conforming loan backed by Fannie Mae or Freddie Mac.
However, they are commonly found on jumbo mortgages, typically with big banks that hold them in their portfolios.
So if you’re looking for an interest-only loan, consider a bank or perhaps a credit union that makes its own mortgage guidelines.
Just note that you might need to deposit a considerable amount of money to qualify.
Pros and Cons of Interest-Only Mortgages
Benefits of interest-only mortgages
- Smaller monthly mortgage payment
- More affordable if money is tight (improved cash flow)
- You can buy a bigger/more expensive home today
- Excess cash each month can be used for other higher-yielding investments, retirement, Roth IRA, etc.
- Or to pay off student loans, credit cards, personal loans, etc.
- Less money locked up in an illiquid asset
- You can still build equity if home prices rise over time
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