What Are Interest-Only Mortgages and How Do They Work

    An interest-only (I/O) mortgage is a type of mortgage in which the borrower is only required to make interest payments for a set initial period.

    After the initial interest-only period, you can make regular monthly payments (that include both principal and interest), refinance into a different loan program, or pay the remaining balance in a lump sum.

    Interest-only mortgages can be helpful for several reasons, but it is important to understand the drawbacks when determining if this loan type is a good fit for you.

    There are very few options available for a fixed-rate interest only mortgage. Most interest-only loans are structured as an adjustable-rate mortgage (ARM). The term to make interest-only payments typically lasts 3, 5, 7, or 10 years based on the loan program you choose. After this introductory period, you will begin to repay both principal and interest.

    Because the interest rate on an ARM can increase or decrease after the initial period of your loan, your payments can change as a result.

    Qualifying for an Interest-Only Mortgage

    There are several factors taken into consideration when assessing qualification for an interest-only mortgage.

    Qualification is based on the borrower’s ability to make projected monthly payments when the interest-only period ends. To qualify for an interest-only mortgage loan, you will likely need to meet the following criteria:

    • Good credit score (recommended FICO score >700)
    • Sufficient income and assets to repay the loan
    • In some cases, a larger down payment (most lenders require between 15% to 25% down)

    Advantages of an Interest-Only Mortgage

    The main attraction of interest-only mortgages is keeping your initial month-to-month housing costs low. By only paying interest on your mortgage, you would be able to save the cash that would be going to principal and use those funds elsewhere.

    Another advantage of interest-only mortgages is that they offer initial tax benefits. Since you can deduct mortgage interest on your tax return, an interest-only mortgage could result in significant tax savings during the initial interest-only period.

    In addition to lower monthly payments and potential tax benefits, the initial rate is often lower than a traditional 30-year fixed rate mortgage. In most cases, ARMs enable borrowers to be approved for a higher loan amount and purchase price because they are priced lower than 30-year fixed rate loans. Depending on the yield curve, borrowers can get up to a 1% lower interest rate with an ARM.

    Interest-only loans are particularly helpful for clients that are frequent movers or clients that are purchasing a short-term investment property. Interest-only mortgage options may be a good fit for you and your family if the following apply:

    • Upward Income Projection – If you currently have a modest income but expect your income to grow in the future (for example: if you are completing a training program/further education)
    • Irregular Income – If your income is mainly based on commission or seasonal income, you may choose an interest-only mortgage because of its flexibility. With an interest-only mortgage, you can make interest-only payments during periods of low income and larger payments when you have more cash.
    • Alternative Investment Needs – Many borrowers choose interest-only mortgages so that they can contribute the money that would be going toward principal payments toward other investments

    Drawbacks of an Interest-Only Mortgage

    Interest-only loans are considered riskier for borrowers than fixed-rate mortgages. Common drawbacks of choosing an interest-only mortgage loan include:

    • Varying Interest Rates – With all adjustable-rate mortgages, you take the risk that rates can rise after your initial fixed-rate period. If rates rise, so will the amount of interest you pay on your mortgage.
    • Payment Shock – Low monthly payments when your loan is in the initial “interest-only” stage will not last forever. Your mortgage payment will go up significantly (often as much as double or triple) aft the initial interest-only period or when the payments adjust.
    • Equity Risks – By making interest-only payments, you are not building equity on your home until you begin making payments toward the principal of the loan. If your home value declines, this could cancel out any equity you had in the property from your down payment. Losing equity in your home can make it difficult to refinance.

    Learn More About Interest-Only Mortgage Options

    Although there are substantial risks with interest-only mortgages, they can be a great option for people wanting to keep their initial housing costs low. They are also helpful for borrowers who plan on occupying their home for a short time or have unique income/investing needs.

    There are several alternative options to interest-only mortgages that are worth exploring before deciding on an interest-only loan:

    • Traditional Adjustable-Rate Mortgage (ARM) – These loans typically offer very low interest rates for a set initial period (typically for the first 3 to 10 years of the loan). They are a great option for clients who plan to move or refinance soon.
    • Conventional Fixed-Rate Mortgage – This loan type is the most common in the mortgage industry and features a fixed payment that will remain for the life of the loan.
    • FHA Loan – This loan type has more flexible qualification requirements and only requires a minimum down payment of 3.5%. This option is ideal for buyers who don’t have a lot of cash for a down payment and have less-than-perfect credit.

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