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What Is An Interest-Only Mortgage?

7-minute readNovember 29, 2021

An interest-only mortgage begins with a fixed low payment period. During the introductory period, you only need to pay off the interest that accrues on your loan. This can be a solid choice if you don’t have enough money to cover your monthly payments now. However, you’ll need to be sure you can begin making larger monthly payments as soon as your introductory period ends

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Who Is The Interest-Only Mortgage For?

Like any other type of mortgage, there are both benefits and drawbacks to choosing an interest-only loan.

Benefits

  • Interest-only loans allow you to wait for your income to increase. Is your income low now but you expect that it will increase in the next few years? An interest-only loan can be beneficial. For example, let’s say you’re in law school right now. You might not be able to make a full mortgage payment each month. However, once you graduate, your earning power will significantly increase. An interest-only loan can allow you to buy a home with payments that are in line with your future earnings.
  • Interest-only loans can allow you to wait for a windfall. An interest-only loan can be ideal if you know you’re set to receive an inheritance or trust within a few years. Maybe you’ve found the perfect property, but you don’t have the cash for your monthly payments – an interest-only loan can allow you to move in now.
  • Interest-only loans can allow you to speculate. Let’s say you think that the value of a property will continue to rise in the next few years. You can buy the property with an interest-only loan, then sell the home at a higher price before your full repayment period begins. This is a common strategy that refurbishing professionals and house flippers use to maximize their profits.
  • Interest-only loans let you direct money to debt. A mortgage is one of the cheapest ways to borrow money. The average 15-year fixed mortgage has an interest rate of 3.5%, while the average credit card has an interest rate of about 17.78%. If you have high-interest debt, you can take an interest-only mortgage and divert your funds to your debt. You can save thousands of dollars in interest if you’re able to get out of debt before your standard repayments begin.
  • Interest-only loans give you a tax break. You can deduct interest on up to $750,000 of your home value if you bought your home after December 16, 2017. However, this deduction only applies if you itemize your taxes. You can deduct your entire monthly interest-only payments when tax season rolls around if you itemize.
  • Interest-only loans allow you to invest your money elsewhere. Do you have an urgent investment that you need to make? Interest-only loans free up your cash flow and allow you to invest your money elsewhere. This can be a major benefit for time-sensitive investments.
  • Interest-only loans allow you to pay down equity on your schedule. Most interest-only loans have no restrictions on extra principal payments. For example, let’s say you enter an interest-only loan schedule and you have cash sooner than you expected. You’re free to make extra payments on your principal if you don’t fall into the money you were expecting. You’re also free to continue making interest-only payments until full repayment begins.

Disadvantages

  • Interest-only loans don’t help you build equity. Equity refers to the percentage of your home that you own. You must make payments on your home’s principal balance in order to build equity. You don’t gain any equity until you start making full monthly repayments with an interest-only loan.
  • Interest-only loans cost more over time. Interest-only loans cost more over time than ARMs and fixed-rate mortgages because you pay interest over a longer period and put off reducing your principal balance.
  • Full repayments can be a shock. After years of paying interest only, suddenly switching to a full repayment can hit your wallet hard. Be 100% sure that you can make your full repayments before you accept an interest-only loan.
  • Your speculation might fail. Interest-only loans can be very beneficial if your home’s value rises. But what happens if its value falls? You’ll still be on the hook for your loan’s full value if your home decreases in value during your interest-only repayment period. This can limit your ability to sell or refinance, which can present a serious problem for investors.
  • Interest-only loans are less common. Interest-only loans are riskier for lenders than other types of loans. Due to current financial conditions, fewer mortgage lenders now offer interest-only loans. You may need to consult with a few lenders before you find a lender willing to offer you an interest-only loan.

How Do You Apply For An Interest-Only Mortgage?

Applying for an interest-only mortgage begins with finding a lender to service your loan. Start by contacting lenders and ask if they offer interest-only options. Interest-only mortgages are less common now than in previous years. You may need to speak with a few lenders before you find one that can help.

After you find a lender that offers interest-only loans, submit an application for preapproval. Many lenders now allow you to apply for a loan online. A preapproval is a letter that lets you know about how much you can afford to get in a home loan. Preapproval letters are important because they tell sellers and real estate agents that you can afford to buy the home that you’re interested in. Once you get preapproved, you can start shopping for a home.

Your lender will ask you questions about your credit and finances. Interest-only loans often have higher qualification standards than other types of loans.

Don’t worry if you didn’t qualify for an interest-only loan. There are a number of other loan types that you can use to buy a home with lower credit and down payment requirements.

Additional Mortgage Options

Can’t find an interest-only loan? Consider one of these interest-only alternatives.

ARM

Disclaimer: Rocket Mortgage® does not currently offer 5-year ARMs.

An adjustable rate mortgage has an interest rate that changes with current market conditions. ARMs begin with a short period of fixed interest, usually lasting 5 – 10 years. During the fixed period, you’ll pay interest at a rate that’s lower than current market rates. After your fixed period ends, your loan’s interest rate goes up or down, depending on the market. ARMs include clauses that limit how much your interest rate can rise or fall during adjustments and over the course of the loan.

ARMs are a great alternative to interest-only loans. During your fixed period, you’ll have access to a lower-than-average interest rate. ARMs also allow you to instantly begin building equity, which is beneficial if you decide to refinance later on.

Fixed-Rate Mortgage

Consider a fixed-rate loan if you need a predictable monthly payment. A fixed-rate mortgage keeps the same interest rate throughout the term of the loan. This means that you’ll pay the same amount every month unless you fall behind on your payments or you pay more toward your principal. Like an ARM, a fixed-rate loan allows you to begin building equity on your home immediately.

Consider a 30-year fixed-rate mortgage if you need low monthly payments and need to ensure that your payments remain the same. Longer mortgage terms give you more time to pay off what you owe, which lowers your monthly payment. Though a longer term will make your loan more expensive, a 30-year term can be beneficial if you need a lower payment now.

Balloon Mortgage

A balloon mortgage is a unique type of home loan that begins with standard monthly payments. Some balloon mortgage structures allow you to only pay off accumulated interest during your term. Balloon mortgages usually have very short terms, usually 5 – 10 years. After your term ends, you must make one large payment equal to the remaining balance on your loan. You must pay off the entire balance of your loan at the end of your term if you have a balloon mortgage that only requires monthly interest payments. You may or may not have the option to refinance your balloon payment, depending on your lender.

A balloon mortgage can be a solid option if you know that you’ll receive a large amount of cash in the next few years. Unlike an interest-only loan, a balloon mortgage will also give you access to a lower interest rate and save you money over time. However, balloon mortgages are very risky for lenders. Fewer lenders now offer balloon mortgages than in previous years.

If you aren’t positive that you’ll be able to make your balloon payment, a balloon mortgage can also be risky for you as the buyer. You may be able to refinance your lump-sum payment and your lender can also move your home into foreclosure if you can’t pay.

Apply Online with Rocket Mortgage®

Get approved with Rocket Mortgage® by Quicken Loans® – and do it all online. You can get a real, customizable mortgage solution based on your unique financial situation.

Summary

An interest-only loan is a type of mortgage that allows you to only pay interest during an introductory loan period. During this introductory period, you don’t build any equity in your home, but your payments are very low and easily manageable. After your introductory period ends, your lender reamortizes your loan. You then begin making monthly payments that include both interest and principal.

An interest-only loan can be a good choice if you know that your income will increase in the next few years. You may know you’ll make significantly more money later on and be able to afford much higher monthly payments. Interest-only loans can also be beneficial if you know you’ll receive an inheritance soon, you have an urgent investment you need to make or if you have high-interest debt.

Interest-only loans do have drawbacks. They tend to cost more because you pay interest over a longer period of time. They also put off equity building, which can be a problem if you want to refinance or sell your home. A balloon mortgage or ARM can offer a sustainable alternative to an interest-only loan. For more resources like this one, be sure to check out our home buying and personal finance learning centers.

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