What is an Interest-Only Mortgage?

In this article:

• What is an Interest-Only Mortgage?
• Pros & Cons
• Who These Loans Make Sense for, Who They Don’t
• Availability

What is an Interest-Only Mortgage?

An interest-only mortgage loan allows borrowers to pay only the interest on the loan for a fixed period of time - usually 5 to 7 years - and then must begin paying off the principal.

At any time during the interest-only payment period, however, the borrower can pay down the principal, too, if they choose. Then, once that interest-only period is up, the borrower may choose to refinance, repay the remainder of the loan in one big payment or begin paying principal and interest each month like it’s a traditional mortgage.

Here’s what you need to know about interest-only loans.

Interest-Only Mortgage Pros & Cons

The main benefit of an interest-only loan is its low initial monthly payments (because you’re just paying the interest on the loan) and the flexibility of the initial payments (because you can pay down the principal along with the interest, but you don’t have to).

The downside is you’re not building up any equity in your home during the initial part of the loan, which often lasts for seven years. Plus, in a few years, your required monthly payments will increase significantly, so you have to be ready for that.

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Who Should Consider an Interest-Only Mortgage

Interest-only mortgage loans may work well for a person who isn't making much money now but knows he will in a few years; someone whose income comes mostly from irregular bonuses or commissions; or someone who plans to smartly invest the difference between what he would have been paying monthly with a traditional mortgage and what he is paying with the interest-only loan.

On the other hand, these loans probably don’t make sense for someone who makes a steady salary and doesn't think he’ll earn significantly more later or someone who is hoping to build equity in a home so he can later take out a large home equity loan to make improvements on the home.

Interest-Only Loan Availability

Before the housing market collapse, interest-only loans were all the rage, with banks giving them even to unqualified buyers. Nowadays, it’s harder to find and qualify for one.

Not only did banks cut down the number of these loans they offered after the housing crisis, new regulation will likely curtail them being offered in the future. In January 2013, the Consumer Financial Protection Bureau created new rules that go into effect in 2014 designed to protect consumers from “risky lending practices” such as interest-only loans.