Interest only mortgage payments appeal to many because of the low monthly payment. But are they a good way to go? We list the pros and cons.
A while back, a Consumerism Commentary reader named Ryan suggested I write about interest-only mortgages. I thought this was an interesting request. So I definitely wanted to address the topic.
First and foremost: there is no such thing as an “interest-only mortgage.”
Wouldn’t that be nice? To have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, though, that’s not going to happen. When you become a borrower, your lender will insist that you pay both interest and, at some point, principal.
What does exist, however, is an interest-only payment option for mortgages.
What Is An Interest-Only Payment Option?
The interest-only option can apply to adjustable-rate mortgages and fixed-rate mortgages alike. The purpose is to allow borrowers to reduce monthly payments for a period of time, usually somewhere between three and seven years at the beginning of the mortgage term.
For example, let’s say that you buy a home with a monthly payment of $1,200. At first, $600 goes to interest, and $600 goes to the principal. If you use the interest-only payment option for a while, your monthly payment would start out at just $600. You would pay this interest-only amount for a predetermined number of years. During that time, the actual loan principal balance remained unchanged (unless you chose to pay extra). Then, at the end of the term, your payment would jump up to the original amount ($1,200). At this point, you would begin repaying the principal, as well.
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Who Uses It?
There are many types of people who would likely consider interest-only loan terms. These include:
- Those who want to buy a home, but want to buy more than they can actually afford right now.
- Buyers who know they’ll sell the home quickly, and so don’t want to tie up extra funds in a higher monthly mortgage payment.
- Buyers in a financial situation where they need lower payments now, but know that they’ll be able to afford higher payments later on.
- Those who want to take invest the money saved each month, confident they can get a better rate of return this way than with paying down their mortgage principal. This could also apply to buyers who want to pay off high-interest debt with the money saved.
The lower monthly payments during the interest-only period are good for households with irregular income. This comes into play with those who receive commission payments less frequently than on a monthly basis. It’s also beneficial for households with unpredictable income, such as a business owner who is expecting low income while the business is in a period of growth.
Interest-only payment options also allow borrowers to “afford” a more expensive home than their bank account says they can. This can be important for an executive who needs to entertain clients at home. A home’s appearance can be crucial to success in these cases. Buyers may also want to buy a home that’s simply beyond their means for the time being. Perhaps parents want to get their children into a certain school district. They just can’t budget for a full mortgage payment but can afford interest-only payments.
Things to Consider
This repayment option is a dangerous prospect, especially in an environment where you can’t be sure whether the value of the house will rise in the short term.
While making interest-only payments, the borrower is not building equity in the house. If the borrower is not building equity, they are essentially renting their own home. This is especially true if home values are stagnant or falling. The borrower is never paying down what they ultimately owe on the home.
When house values are declining, this problem is compounded. Here, the borrower owes the full purchased value of the house while making the interest-only payments. And the house’s declining values means the borrower will quickly owe more than the home is worth.. Then, if the borrower has to sell, they could wind up owing the lender more than they get from the sale of the home.
In another negative situation, some interest-only payments don’t cover the full amount of interest due each month. This is especially true if the mortgage is at an adjustable rate (ARM), which may increase over time. The excess, non-paid interest is then tacked onto the principal. This means the buyer owes even more in principal than they did originally.
This is called negative amortization. Not only is the borrower not adding equity at that point, but they’re digging a hole even deeper. And they haven’t even reached the increased monthly payment period yet!
Another downside to utilizing this interest-only option is that many people are not disciplined enough to invest or save the difference each month. Instead, they spend it. This means that they put themselves in a tight position with their home for no reason. And they may have nothing to show for it in the end.
When the Interest-Only Period Ends
Interest-only payment options don’t last forever.
After the determined period of time ends, the lender will expect the borrower to start paying back the principal, as well. This usually means a significant increase in the monthly mortgage payment.
What if the borrower’s income hasn’t increased as expected or if their business has not moved past the “growth” stage? In this case, the new payment might simply be unaffordable. Plus, the payment will typically be even larger than it would have been had the buyer chosen a standard 30-year mortgage to begin with.
So, what’s a borrower to do? They have a few options.
The buyer can find a way to increase monthly payments. So they can pay down the mortgage principal and any negative amortization quickly. Then they can sell the home. Or if they want to keep the home, they can refinance the mortgage. They could check out a lower interest rate or do yet another interest-only payment period. Or they can stretch the balance back out over 30 years to make the payment more affordable.
The problem with selling or refinancing is that it’s largely contingent on the home’s value and equity at the time. If the mortgage is now upside down, it will be difficult to make either move. You’ll end up owing money to the lender if you sell. And in order to refinance, you may need to have extra cash on hand.
Is Interest-Only Right for You?
Determining whether an interest-only option is right for you can be tricky. After all, you’re playing a very risky numbers game that requires discipline.
Let’s take a look at just how different your situation will be if you go the interest-only route versus simply paying off your mortgage traditionally. To demonstrate this, the Federal Reserve Board has a helpful comparison chart outlining the differences in payments you might expect if you choose an interest-only payment option, reproduced below. Notice how low the equity is in the last column, identifying borrowers who opt for the interest-only method.
- If saving/investing the money–Am I disciplined enough to invest the difference each month? Am I also as certain as can be that I will earn a higher return on this money by putting it elsewhere than I would save by paying off my mortgage on a typical schedule?
- If expecting income to increase–What is the likelihood that my income will increase as expected over time, so that I can meet my increased payments after the interest-only period ends? What are my options if this doesn’t happen?
- If planning to sell soon–What is my reason for selling after a short period of time, and what are the odds that this could change? Can I still afford this home if I don’t sell or am unable to sell?
- Do I have additional savings at the ready, so I am safe if I wind up underwater on my mortgage? In that case, I may need to put down an additional payment for a refinance or to close out with the lender if I sell.
Best Lenders for Interest-Only
Since interest-only mortgages played a role in the foreclosure crisis of a decade ago, banks don’t tend to offer them nearly as often. When they do, there are often high qualification requirements, usually in the form of excellent credit and high asset wealth. With the former, this ensures that the borrower can still afford the payments when they suddenly increase, avoiding the “payment shock” that has plagued many.
Some lenders do still offer these types of mortgages, but you’ll have to look a little harder. You can start by looking up basic mortgage rates through an online aggregator. Then request additional information from the lender regarding interest-only payment options. Be prepared for them to confirm your excellent credit and higher net worth before approval. And be ready for the loan to (likely) be an adjustable-rate mortgage (ARM).
Banks like Navy Federal Credit Union, Wells Fargo, and Bank of Internet USA still offer this option. You can also look into interest-only mortgage options through SoFi.
Do you have or have you had an interest-only payment option on a mortgage? Please share your experiences or opinions.
Published or updated November 8, 2017.