With most mortgages, the monthly payment consists of a portion of interest and principal, which means the borrower will pay on both at the same time. Interest only mortgages are different, as they allow homeowners to pay only interest on the monthly payments for a specific amount of time, (usually between five and ten years), while the principal balance on the loan remains unchanged.
The main advantage to an interest only mortgage is the monthly payments are reduced, allowing borrowers to buy a more expensive home than they could otherwise afford.
Borrowers who typically consider interest only mortgages are the following:
- Buyers who are fairly sure their income will increase, but want to buy a more expensive home today.
- Buyers who are more interested in a lower payment than building equity in the home.
- Buyers who want to invest their money elsewhere.
- Buyers who are self-employed and able to make a hefty down payment and while maintaining a high balance in their bank account.
- Buyers who understand and accept the idea that their monthly payment will go up when the interest only period ends.
- Buyers who own investment property.
Interest Only Mortgages and New Mortgage Rules
Interest only mortgages were popular during the housing bubble, and remain a popular loan option to qualified buyers. Still, it is important to understand that new rules enacted by the Consumer Financial Protection Bureau, which went into effect in January 2014, exclude interest only mortgages from Qualified Mortgage status. Qualified Mortgage Status protects lenders from liability of the loan if the loan later defaults.
Today, interest only loans are generally only offered to well-qualified buyers who can afford a large down payment and have substantial assets.
Downsides of an Interest Only Mortgage
Because interest only mortgages do not amortize, borrowers can more quickly become underwater on the loan if the real estate market turns and home prices drop. The best way to avoid this, is to provide a substantial down payment, which gives the buyer immediate equity in the home.
Monthly payments can also rise dramatically when the interest only period ends, so buyers must be sure they will be able to afford the larger payments when the time comes.
Borrowers should also be aware that it can be harder to refinance the mortgage with an interest only loan if home values do not increase and the home has no equity.
The strict requirements for an interest only loan can also make this option impossible for some borrowers, as most lenders require a large down payment, excellent credit and substantial assets.
Advantages of an Interest Only Mortgage
- Interest paid on a mortgage is tax deductible. Because the entire payment will be interest only for 5-10 years, borrowers can deduct their entire payment.
- Monthly savings can be used for investments and higher returns than today's mortgage rates.
- Real estate investors can choose a 5/1 interest only adjustable rate mortgage (ARM) to profit from any appreciation in the home, while maintaining the lowest mortgage payment possible.
- Interest only mortgages are available in many forms, including option ARMs, 30-year fixed-rate mortgages with a 10-year interest only period, 3/1 ARMs, 5/1 ARMs and 7/1 ARMs.
- Interest only mortgages do not require the homeowner to make interest only payments, but it does give the borrower the option. This means homeowners facing a large, unexpected bill can use this option to make a single interest only payment.
- Buyers with income that fluctuates, such as earnings from commissions instead of a salary, benefit by making interest only payments during slow months and paying extra towards principal when commissions or bonuses come in.
While interest only mortgages are not for every borrower, they do offer a great deal of benefits to the right buyer with a unique situation.