If you need time to start paying principal on a mortgage, consider an interest-only mortgage. With an interest-only mortgage, you will repay the principal in a lump sum on a specified date or according to a payment schedule set in the future. These mortgages are typically a type of adjustable rate mortgage that may offer greater convenience to some borrowers. Read on to understand when an interest-only mortgage makes sense and if it’s the best option for you.
Understanding the concept of an interest-only mortgage
An interest-only mortgage is a type of mortgage in which the borrower only pays interest for a certain period or term. After this period, the principal balance is due either in installments or in the form of a lump sum. This differs from other types of mortgages where you pay principal and interest with each payment.
When you pay an interest-only mortgage, you are not building equity, but only covering the interest owed. Why would you want an interest-only mortgage? Let’s say you’re in the process of selling a home, business, or asset while purchasing another. With an interest-only mortgage, you can only pay the interest until you have a lump sum.
With lower monthly payments, interest-only mortgages can also make sense for investors who need to spend time rehabbing a property before renting it out. During the renovation process, their monthly costs will be lower until the house can be rented.
How does an interest-only mortgage work?
Interest-only mortgages can be structured in different ways with different interest-only periods. During the interest-only period, the principal balance remains the same. After the interest-only period, the loan typically converts to a standard schedule in which the buyer’s payments increase to repay a portion of the principal plus interest each month. In mortgage lender terms, this is called a fully amortized basis of the mortgage.
Interest-only mortgages have a fixed period for interest-only payments ranging from five to 10 years. After that, the principal may be due in full or converted to standard principal plus interest payments. Borrowers also have the option of refinancing the mortgage or selling the mortgaged home.
Let’s say you plan to invest in a rental property in a growing market and hold it for up to 10 years. You can get an interest-only mortgage for a period of seven years. The property costs $250,000.
If you make a down payment of $25,000 and take out a loan of $250,000, for the first seven years, your monthly payments will be $1,125 in interest. If you rent the property for $2,000 per month and average $200 per month for expenses such as utilities, maintenance, insurance and taxes, your monthly cash flow is $675. After seven years, when the principal becomes due, assume the property has appreciated and you can sell it for $290,000.
After completing the transaction and repaying the loan, you will earn $65,000. Additionally, you would have had a positive cash flow of approximately $8,100 per year for almost seven years. During this period, you could recoup your $25,000 down payment and achieve a return on investment (ROI) of over 300% on your initial investment over this seven-year period.
Another option for this example would be a loan ratio of 7/1. With this hybrid home loan, you make fixed monthly payments at a fixed interest rate for the first seven years. After seven years, the mortgage is converted to a variable rate mortgage for the remainder of the loan.
Who should consider an interest-only mortgage?
For many people, it makes more sense to pay off the mortgage principal early in the loan term. But suitable candidates for an interest-only mortgage include those who plan to own the home for a short term of less than seven years. For example, if you need to move frequently for work, plan to flip the house, or plan to sell and purchase a larger home during this time, an interest-only mortgage may make sense.
Similarly, some buyers choose an interest-only mortgage for rental properties or second homes that they plan to later convert into a primary residence. In this case, you reduce your monthly payments until you can sell the main residence.
Factors to consider before opting for this type of loan include total monthly expenses, cash flow, and long-term plans for the property. Because interest-only mortgages typically require you to either pay the full principal at the end of the term or refinance, for long-term properties you risk higher interest rates when refinancing or having to arrange the total principal amount.
To ensure responsible borrowing and minimize risk, only take out loans that keep your total debt-to-income ratio at 50% or less of your income. Ideally, try to keep it below 30%. If you plan to rent the new property, you can calculate the expected cash flow from rental income.
Interest-only mortgages impose stricter eligibility requirements on borrowers because banks want to make sure you are able to repay the loan when due. This is why interest-only mortgages are not as common as standard payment mortgages. To get an interest-only mortgage, you may be asked to show:
- Proof of income
- Savings and investment accounts
- Evidence of other assets that can serve as collateral
Advantages of an interest-only mortgage
Interest-only mortgages have many benefits, including:
- Reduced monthly payments
- Increased short-term cash flow
- Flexibility in financial planning
- Possibilities of mobilizing additional funds over a few years.
- Potential tax benefits for certain borrowers
- Deferred payments
Disadvantages of an interest-only mortgage
The potential disadvantages of an interest-only mortgage focus on deferred principal payments. The main disadvantages include:
- No creation of own funds
- Potential negative depreciation
- Higher risk for borrowers during repayment period
- Possible difficulty refinancing or selling the property
To avoid these drawbacks, borrowers must be very careful in calculating future cash flows. Interest-only mortgages can be convenient for several reasons, but increase the risk of default.
Alternatives to interest-only mortgages
Borrowers may consider other types of mortgages, including a traditional mortgage, an adjustable rate mortgage, a bank statement mortgage, or a non-qualified mortgage.
A traditional fixed-rate mortgage offers the convenience of fixed monthly payments and building equity from the first month. Adjustable rate mortgages can offer a lower initial payment period, comparable to interest-only mortgages, while still building equity. Consider each based on your financial goals and your intention to keep or sell the property over the next five to 10 years.
Should you get an interest-only mortgage?
Frequently asked questions
A interest only mortgage allows you to get a mortgage while making lower monthly payments for the first five to 10 years of the mortgage term. If you plan to sell another property or vacate the property before interest only mortgage term is coming, it may make financial sense for many people.
The riskiness of interest-only mortgages varies depending on your financial situation. If you have significant savings or an asset like another property you are considering selling, the benefits and convenience of a interest only mortgage could outweigh the risks.
At the end of an interest-only mortgage, the terms vary depending on the lender. In some cases, the entire capital will be due. In other cases, you can start paying principal and interest over the life of the mortgage. Finally, you could refinance the property with a traditional mortgage.