What is an Interest-Only Mortgage?
Interest-only mortgages can be structured in assorted ways, but they share a common premise. Borrowers don’t have to pay principal for a period, usually three to 10 years, lowering their monthly payments below the cost of comparable principal-and-interest mortgages.
If you have a good memory (one that extends back more than a decade), you might recall that interest-only mortgages were part of the worst housing market debacle since the Great Depression. This product allowed homebuyers access to property they could have otherwise never afforded.
We all know how that ended. When the housing market crashed in 2008 and forensic economists tried to learn exactly what went wrong, much of blame landed on interest-only mortgages and the lenders who pushed them.
What makes these loans potentially dangerous? They encourage borrowers to buy more expensive houses than they could using conventional financing. During the bubble years of the early 2000s, lenders were fine with that. It was a big mistake.
As the interest-free periods of thousands of mortgages ended, homeowner’s monthly payments soared. Many couldn’t afford paying interest and principal, and they defaulted on their loans. Foreclosures skyrocketed, banks went bust and the Great Recession nearly sunk the economy.
As devastating as that tract was, interest-only loans endure, but under tighter financial regulation. Today, they are most common in the high-end real estate market, where buyers seek to delay repaying principal as part of larger financial strategy.
Types of Interest-Only Home Loans
The days when lenders encouraged customers to take interest-only loans to buy houses they normally couldn’t afford are over, but interest-only mortgages are still available, including these:
Interest-only jumbo mortgages are large loans of up to $650,000 and are one area where interest-only loans remain popular. Wealthy buyers who are reaping large returns in the financial markets might be reluctant to divert money to mortgage principal, which offers no return until the house is sold. Under the Dodd-Frank Act, a federal law passed in 2010 to protect against a repeat of the 2008 housing-market meltdown, buyers must meet certain standards to qualify. No-principal loans don’t fit the description, but lenders are willing to write interest-only if a borrower meets high standards.
30 Year Interest Only Mortgages
These resemble conventional 30-year mortgages with a caveat: borrowers don’t pay principal at the outset, usually for the first 10 years. Since the repayment period is the same as a standard 30-year loan, monthly principal payments in the final 20 years would be higher than they would if principal were paid from the beginning. Lenders generally want larger down payments and charge higher interest for these loans since they are considered risker than conventional loans.
Home equity lines of credit, or HELOCs, are typically interest-only for the first 10 years. HELOCs are really second mortgages that work like credit cards – borrowers can draw money that uses the equity in their homes as collateral. For example, a borrower could take a HELOC for $100,000 with a 30-year repayment period. During the first 10 years, the borrower could use as much of the credit line as desired, only paying interest on the balance due. After 10 years, the credit line is frozen and the balance is paid off during the remaining 20 years.
Advantages of an Interest-Only Mortgage
Interest-only mortgages can be a boon to buyers capable of making bigger payments in the future in exchange for savings in the near-term.
Here are a few examples of when they might work for you:
- Rising Income. Say you are finishing medical school and want to buy a house. You’re spending almost all you have on tuition and borrowing money you don’t have, so adding a mortgage payment to the mix would be impossible. But you’re counting on a big paycheck as a surgeon after you complete your internship, so you are very confident about your financial future. Taking an interest-only loan would hold down your homebuying costs, and making the higher monthly payments in 10 years should be no problem when you make a bundle in private practice.
- Qualify for a Bigger House. This was one of the problem strategies during the housing bubble. It works if you have a lot of money in your future, like an inheritance, but can be trouble if you couldn’t afford to house you want with conventional financing now. When the interest-only period ends, your loan payments will balloon and you must be ready to make larger payments or refinance.
- Rising Housing Prices. This was another strategy during the housing bubble. In a soaring housing market, speculative buyers used interest-only loans to leverage buying property they couldn’t finance with a conventional loan. Typically, the strategy involved selling, or flipping, the property after a few years. It worked for quite a few people, but those still holding their homes when the bubble burst faced calamity.
- Investment strategy. If you have a stock portfolio that’s growing in a healthy financial market, you might be reluctant to sell investments to make mortgage payments. Or maybe you have the cash flow to make payments, but would rather invest your money in equities or a retirement plan. In either case, an interest-only loan might serve your purpose.
- Tax Deduction. Mortgage interest paid on home loans of as much as $1 million is deductible. For some investors, that’s a financial plus and makes an interest-only loan desirable. If you have a big income and are in a high tax bracket, the mortgage interest deduction can be useful in holding down your income tax payment, and your entire mortgage payment is tax deductible, not just part of it.
- Pay Equity on Your Schedule. Most interest-only loans don’t restrict you from making extra payments to lower your principal. You can do this whenever you like, and it will generally lower your monthly interest payment. This can also be useful if you have variable income that means you can pay more some months are less others.
Disadvantages of an Interest-Only Mortgage
Interest-loans can be risky, especially if you find you are unable to jump to a higher monthly payment when it’s time to start paying principal. Since new federal consumer-protection guidelines took effect in 2013, lenders know what sort of loans they can offer and to whom.
Here are other things you should consider before pursuing an interest-only mortgage:
- No Equity Growth. Interest-only mortgages today generally require large down payments so lenders have collateral against default. But for the first five to 10 years of the loan, the homeowner’s equity doesn’t grow at all, unless the owner decides to make extra payments. If your goal paying down a mortgage, interest-only loans are a bad place to start.
- Home Values are Falling. This was another problem made clear in the 2008 housing market meltdown. Many buyers prior to the crash believed housing prices would never fall. They learned a hard lesson. Interest-only loans contributed to the rapid run up in prices, but when the bubble burst and prices fell, interest-only mortgage holders were suddenly making big interest payments on houses in which they had little equity. Many just walked away.
- Riskier loans with Higher Interest Rates. Lenders who still make interest-only loans want to protect the money they lend. Since interest-only loans, which were once easy to sell to other financial institutions, are now less marketable, lenders demand larger down payments from borrowers and they charge more interest than on conventional loans, which are considered a better risk. Mortgage interest rates correspond to risk, and the more risk to the lender, the higher the rate.
- Variable Interest Increases. Interest-only loans often come with variable interest rates, meaning the rates adjust in relation to a benchmark funds rate. If funds rates rise, so does the amount of interest you pay on your mortgage or HELOC. You might want to look for loans that allow you to lock and unlock interest rates, allowing you greater certainty what future payments will be.
What You’ll Pay Each Month
Monthly payments depend on your interest rate and whether the interest rate adjusts during the repayment period or is locked at a fixed percentage of the balance. It’s important to remember that during the no-interest period of the loan, your equity balance won’t change, which means you will never pay less each much unless your interest rate adjusts lower.
Here’s an example of how it works: You buy a $350,000 home and make a $150,000 down payment. You take a 30-year mortgage interest only loan that carries a 7% interest rate during the first 10 years. During the interest only period, the monthly payment will be $1,166.67, unless your interest rate adjusts. After that, you begin paying both interest and principal and the loan amortizes mortgage for the next 20 years.
A key difference between a conventional fixed and interest-only loans: Payments on a conventional loan is the same every month, but the amount of interest you pay, gradually falls and the principal portion increases as the loan is paid down. An interest-only loan payment is based on both the interest rate and the balance, so it can be variable. If the interest rate adjusts, or you make extra principal payments, the monthly payment can change. And, of course, when the interest-only period ends, the minimum monthly payment will jump.