Interest rates have reached heights we haven’t seen in years, leading many people to explore creative financing options. An alternative that is gaining ground in this climate is interest only mortgage.

But what is an interest-only mortgage? Interest-only mortgages are a financing option that allows borrowers to make interest-only payments for a set term, typically seven to 10 years. Once the introductory period ends, borrowers must pay principal and interest for the remaining amount of the loan term at a variable rate.

Choosing this financing option could be the key to making your homeownership dreams affordable. In this article, we’ll cover the ins and outs of interest-only mortgages, including how they work, their pros and cons, and how to qualify for this loan product.

Key takeaways

• Interest-only mortgages generate interest-only payments for a specified period of time, helping to lower monthly payments.

• Interest-only mortgage eligibility criteria include a minimum credit score, debt-to-income ratio below 43%, funds for a down payment, stable income stream and other assets.

• One of the main challenges of interest-only mortgages is the risk of default due to higher interest rates.

• Interest-only mortgages may be a good idea if you hope to earn more income before the term expires, can invest the difference for additional returns, or plan to keep the loan only for a short period of time .

How do interest-only mortgages work?

Interest-only mortgages defer principal payments for a set period of time, making your monthly payments more affordable. However, once the grace period has expired, you must make principal and interest payments, often at varying interest rates.

Some lenders may also require balloon payments with an interest-only mortgage. For example, you may have to repay the entire principal balance after the interest-only period has passed. There are no standardized terms for interest-only mortgages, so it’s always best to shop around for the most favorable terms.

Interest-only mortgages: a real-life example

Let’s say you want to take out a $350,000 mortgage with a 20% down payment. Your lender offers the option of two years of interest-only payments at 6.0%. After the two-year grace period, your interest rate becomes variable for the remaining 28 years. Here’s how your payment is calculated for the first two years:

• Monthly interest rate: 0.06 / 12 = 0.005%

• Monthly payment: ($350,000 – $70,000) * 0.005% = $1,400

• Annual interest paid: $1,400 * 12 = $16,800

For the first two years, you would pay $1,400 per month. Now let’s assume that interest rates increase after your two-year interest-only period. The variable rate is now 7.50%. Use a mortgage calculatorwe see that our new monthly payment is $1,996.03. After a full year of payments ends, here’s how your payment is distributed:

• Remaining capital: $280,000 – $3,056 = $276,944

• Annual interest paid: $20,896

• Total interest paid: $390,665.82

Keep in mind that interest rates may also drop between the time you take out an interest-only mortgage and the expiration period. This would help reduce the amount of interest you pay over the life of the loan.

Interest-only mortgage lump sum payments

Interest-only mortgages may have balloon payments. Keeping our initial factors the same as above, let’s explore this situation, assuming your lender requires a lump sum payment that covers the remaining principal after five years.

• Annual interest payment: $1,400 * 12 = $16,800

• Total interest paid: $16,800 * 5 = $84,000

As you can see, the total interest paid over the life of the loan is much less than with an interest-only mortgage. However, the lump sum payment requires the full repayment of $280,000 after five years. For many borrowers, it is impossible to raise this type of capital after five years.

Finding and Qualifying for an Interest-Only Mortgage

Interest-only mortgages are harder to find, in part because of this loan product’s poor reputation during the 2008 financial crisis. Additionally, interest-only mortgages create more risk for lenders. Although lenders receive monthly interest payments, the borrower’s risk of default is higher when payments return to normal levels. If you find a lender that offers interest-only mortgages, you must meet specific eligibility criteria. Here are some common qualifying criteria:

• Credit score of 700 or higher

• A debt ratio below 43%

• 20% or more deposit

• Stable income with proof of future income

• Other assets you own

It is important to remember that each lender has different eligibility criteria. For example, some lenders will be more lenient about your debt-to-income ratio when you use a larger down payment. Still, lenders look for someone who can easily afford higher monthly payments after the interest-only period, has a stable source of income, and has other assets in the event of default.

Interest-only mortgages are risky

Interest-only mortgage payments may seem like a great idea, but it’s important to consider the risks. Let’s go back to 2008 and discuss how this loan product contributed to the financial crisis.

Many lenders offered borrowers interest-only mortgages to increase homeownership and close more loans. However, once the grace period ended, borrowers were no longer able to make their monthly payments, which included principal and interest. With high interest rates, borrowers began to default on their payments, leading to the bursting of the housing bubble.

Before taking out an interest-only mortgage, it’s important to understand its affordability once regular payments begin. Returning to our original example, the monthly payment increased from $1,750 to $2,447.25. These figures also do not include the rising costs of insurance and property taxes.

If you’re struggling to make interest-only payments, you likely won’t be able to pay the mortgage once the grace period ends, especially during times of rising interest rates.

Interest rates also present another risk with interest-only mortgages. No one can predict what the market will do in the future, which means you have no idea how interest rates will change a few years from now. As a result, it is safer to lock in an interest rate for a 30-year term rather than hoping that rates will fall over the next few years.

When they might be a good idea

Despite the risks, interest-only mortgages can be advantageous in certain situations. On the one hand, if you anticipate a higher income in the future, it might make sense to take advantage of an interest-only mortgage.

For example, your income may be temporarily lower if you just graduated from college. Over the next few years, you could expect to see a significant salary increase. Additionally, if you sell or plan to refinance your loan before payments increase, you may be able to save money with an interest-only mortgage.

Interest-only mortgages also have the ability to generate additional returns. For example, if your interest-only rate is 5% and the stock market returns an average of 10% each year, you can invest the difference between your interest-only payment and your regular payment to generate more returns. This method also ensures that you can pay the normal mortgage payment once the interest-only period has expired.

Alternatives to interest-only mortgages

If you’re looking for a lower monthly payment during the first few years of your mortgage, you have options other than an interest-only mortgage. On the one hand, lenders offer adjustable rate mortgages, called ARMswhich offer a fixed interest rate for a specific period. After this period, the rate becomes variable.

For example, you may be able to receive an interest rate of 5.00% for the first three years of your loan. Once the first three years have passed, your interest rate adjusts each year based on the prime rate. The biggest downside to this method is the likelihood that your rate will increase after the initial term.

Additionally, if you’re trying to reduce your loan payments, some government-sponsored programs and grants could help. These programs vary by state, so check with your local housing department for more information.

Refinance an interest-only mortgage

Taking out an interest-only mortgage does not mean you are bound by the terms for the entire term of the loan. Instead, you can refinance your interest-only mortgage, either into another interest-only mortgage or into a conventional loan with a fixed interest rate. Refinancing requires you to go through the underwriting process again, just like when you took out the original mortgage.

Your lender will look at your credit score, debt-to-income ratio, existing equity, and any additional down payments. If you don’t have enough equity in the home, you may need to put down more down to reduce the lender’s risk. Remember, if you refinance to an interest-only mortgage, expect your rate to be higher. Fixed rates provide more stability in your loan repayment, but are often higher than an interest-only rate.

Do government-backed loan programs offer interest-only mortgages?

No, government-backed loan programs do not offer interest-only mortgages. Interest-only mortgages are non-qualified mortgages, meaning they are not eligible for government-backed loan programs.

Our opinion: know the risks

Interest-only mortgages sound attractive in theory, but they carry risks, such as higher monthly payments, that must be carefully weighed. For most borrowers, the risks outweigh the benefits.