Interest-only mortgages are structured in various ways, but they share a basic concept: Borrowers don’t pay down the principal on their loan for a period, usually 3-10 years.
That means there are some whopping charges waiting at the end of the line.
“It’s not impossible to qualify for one of these loans but having a solid exit plan is essential when using this type of loan product due to its lack of principal paydown,” Joshua Massieh, CEO and mortgage broker at Pacwest Funding in San Diego, said.
Remember 2008, the worst housing market debacle since the Great Depression? Interest-only loans were one product that allowed homebuyers to purchase property they couldn’t otherwise afford. As the interest-only periods ended on those loans, monthly payments soared. Thousands defaulted. Foreclosures skyrocketed, banks went bust and the Great Recession nearly sunk the economy.
Interest-only loans endure but under far tighter financial regulation. The Consumer Financial Protection Bureau (CFPB) requires lenders to examine a borrower’s ability to pay both the interest and principal over the life of the loan and verify that the borrower can make the payments. This process is called “ability to repay.”
What Is an Interest-Only Mortgage?
As the name suggests, an interest-only mortgage is a loan which requires the borrowers to pay only interest for the first few years of the loan’s term. That means attractive, lower monthly payments for 3-to-10 years.
If that sounds too good to be true, just wait for the rest of the truth. After the introductory, interest-only term, the borrower must begin paying down the principal, which has not been reduced by a penny. Not only that, but the interest is still being charged based upon the full amount of the principal, and many loans include an adjustment that could raise the interest rate. So, the monthly payment will balloon to a significantly higher amount, which can be difficult for the borrower to pay.
The conventional mortgages – 30-year and 15-year fixed rate over adjustable rate – generally do not come with this built-in jump in monthly payments. You may have higher monthly payments at the start, but you are paying down the principal and building equity.
Why Get an Interest-Only Mortgage?
Borrowers who pursue interest-only mortgages do so for a variety of reasons.
An interest-only mortgage allows them to get more house for their money. It also keeps their housing costs down for a short period of time, possibly in order to invest money elsewhere.
Interest-only mortgages might also appeal to borrowers who trust the home they purchase will appreciate significantly in the immediate future. In 2008, however, many homebuyers owed more on their homes than those homes were worth when their interest-only payment period ended.
Another reason why borrowers might take out an interest-only loan is to buy a vacation home, the idea being to sell their existing home in short order (3-5 years) and then move into their second home permanently. They would then use the sale of the family home to pay off the interest-only mortgage on the vacation home.
Can I Qualify for an Interest-Only Mortgage?
Interest-only mortgages typically require a larger down payment, higher credit score and a lower debt-to-income (DTI) ratio than conventional loans. The DTI ratio helps lenders determine a borrower’s ability to repay the loan.
Borrowers typically need a credit score of 680 or above to qualify for an interest-only mortgage.
“Lenders also require proof of income and charge several fees to make sure borrowers understand the risks before taking out the loan,” Josh Wilson, Co-Founder at That Florida Life, said. Additionally, borrowers typically have shorter loan terms, which means they have to start paying the principal of the loan sooner than before the 2008 financial crisis.”
Interest-only mortgages are better suited to borrowers with lots of cash in reserve; borrowers who see their income significantly rising in the near future; and those disciplined enough to redirect income spikes toward paying down the principal.
Pros and Cons of Interest-Only Mortgages
You’ve heard of boutique hotels? Think of the interest–only mortgage as a boutique loan. It’s a niche mortgage, not geared toward the average buyer.
Government-sponsored Fannie Mae and Freddie Mac, for instance, don’t even purchase or back interest-only mortgages. The risks and qualifying standards are simply too high for most borrowers.
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 interest-only mortgages might work for you:
- Rising Income: Say you want to buy a house but you’re spending almost all you have on med school tuition and you’re borrowing money you don’t have, so adding a traditional mortgage payment to the mix would be impossible. Taking an interest-only loan would hold down your home buying costs. And, as your private practice grows, you’re confident you can comfortably make higher monthly payments when the interest-only period ends.
- Qualify for a Bigger House: This strategy works if you see a lot of money in your future, like an inheritance. Beyond that, it’s really quite risky. 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 market, speculative buyers used interest-only loans for 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 financial 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 a purpose as part of a well-planned financial strategy.
- Tax Deduction: Mortgage interest paid on home loans of as much as $1 million is deductible. So, an interest-only loan of that size is appealing.
- Pay Equity on Your Schedule: Most interest-only loans don’t prohibit making extra payments to lower your principal. You can do this whenever you like, and it will generally lower your monthly interest payment.
- Rates May Be Lower: While a danger of interest-only or other adjustable-rate mortgages is that interest rates may rise and cost you more money, the opposite is also true. Interest rates can be lowered by the U.S. Federal Reserve in time to save you money. A fixed-rate loan will not change, which protects you from rate hikes but deprives you of the benefit of a rate decrease.
Disadvantages of an Interest-Only Mortgage
Interest-only loans can be risky when the “interest-only” period is up and 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.
“(An interest-only loan) is not suitable for people who are looking to buy a home as a long-term investment or have a limited income and are (simply) looking to reduce their monthly payments,” Nathan Claire, Founder at Buying Jax Homes in Jacksonville, said.
Here are other things you should consider, before pursuing an interest-only mortgage:
- No Equity Growth: Interest-only mortgages generally require large down payments, so lenders have collateral against default. But for the first 5-to-10 years, the homeowner’s equity doesn’t grow at all, unless you make extra payments. If your goal is paying down a mortgage, interest-only loans are a bad place to start.
- Home Values are Not Consistently Rising: Prior to 2008, many homebuyers believed housing prices would never fall. They learned a hard lesson. Interest-only loans contributed to the rapid jump 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 or no equity. Many just walked away. The housing market can be volatile, with home values rising at times – which helps build equity – but also falling at times. It’s risky to count on either trend.
- Riskier Loans with Higher Interest Rates: Interest-only loans were once easy to sell to other financial institutions. Now, lenders demand larger down payments from borrowers, and they charge higher interest than on conventional loans. Mortgage interest rates correspond to risk. The more risk to the lender, the higher the rate.
- Variable Interest Increases: Interest-only loans often come with variable interest rates. So, the amount of interest you pay on your mortgage or HELOC can increase. You might want to look for loans that allow you to lock and unlock interest rates, allowing you greater certainty about future payments.
Types of Interest-Only Home Loans
The days are over when lenders encouraged customers to take interest-only loans to buy houses they normally couldn’t afford. But interest-only mortgages are still available, including these:
Interest-only jumbo mortgages are large loans (up to $650,000) and are one area where interest-only loans remain popular. Wealthy buyers 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 typically don’t pay principal 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 if principal were paid from the beginning. Lenders generally want larger down payments and charge higher interest to offset the risk of default.
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 using equity 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.
An Interest-Only Mortgage Example
You buy a $350,000 home and make a $150,000 down payment. You take a 30-year, 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 up or down. After that, you begin paying both interest and principal and the loan-amortized mortgage for the next 20 years.
A key difference between conventional fixed and interest-only loans: Payment on a conventional loan is the same every month, but the amount of interest you pay gradually falls and the principal 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.
“Another thing to consider is that interest-only mortgages can be more expensive in the long run,” Wilson said. “Without paying down the principal, the loan balance will remain the same. You may end up paying more for your loan over time than if you had taken out a regular mortgage.”
Finding the Right Mortgage for You
Buying a home is the single largest investment most people make in their lifetimes.
There are much less risky loans available than interest-only mortgages but that doesn’t mean taking out those loans requires less planning. Stricter qualifying standards since the 2008 financial crisis underscore the need for prospective home buyers to understand how to get a mortgage, the credit score implications involved in applying for a loan as well as how debt-to-income ratios and down payments influence qualifying for a loan.
Financial professionals have so much to offer in that regard, helping home buyers, especially first-time home buyers, navigate their finances and find the right mortgage for them.
Most prospective home buyers are carrying other debt such as car loans, credit card debt and student loan debt.
Taking on mortgage debt on top of that isn’t an impossibility but might best be tackled with some help. In many cases, those home buyers can greatly benefit from credit counseling for advice in paying down high interest loans, setting a budget and, if needed, exploring a debt management program that offers a comprehensive strategy.
Choosing the right credit counseling agency, like researching the right mortgage for your situation, is a good way to limit risk and grow financial stability.
About The Author
Robert Shaw writes about finding ways to solve financial problems like keeping up with mortgage payments, paying off credit card debt and avoiding bankruptcy for Debt.org. During his 45-year career in journalism, Robert was a columnist for the Cleveland Plain Dealer before transitioning to television sports commentary at WKYC.
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