An interest-only mortgage is a special type of loan that allows you to make only interest payments at the beginning of the debt payment. After a certain period, you can refinance, pay the full amount, or start making monthly payments. Sounds good, doesn’t it? But, believe us, like everywhere else, it has its drawbacks. It is not for nothing that interest-only mortgages are considered a risky option and are only suitable for some. So, let’s understand — what is an interest-only mortgage, and how does it work?
What is an Interest-Only Mortgage?
With a conventional mortgage, your payment covers a portion of the principal plus interest. And in interest-only mortgages — only the percentage of the debt. That is why you pay a smaller monthly payment. This strategy can be followed up to 10 years before you start paying off the entire debt.
Why do you need an interest-only mortgage?
Several reasons make this decision justified.
For example, a person plans to invest and would like to free up cash. It is also suitable for those who want to sell or refinance real estate. Or, it expects to receive more money before the end of the interest payment period.
How does it work?
If someone purchases a house with an interest-only mortgage, sells it before paying off the principal, and benefits from the increase in house prices, they can make a profit.
- Interest-only mortgages are not eligible for the FHA, VA, or USDA government programs.
- Interest-only loans have higher interest rates than conventional loans.
- The maximum loan-to-value ratio is less than traditional loans.
- Most often, banks impose higher requirements for the down payment on such loans.
- Borrowers will need more money than for a government mortgage.
- Many interest-only mortgages are adjustable-rate loans. The annual rate can vary, so the borrower won’t likely have predictable monthly payments on the interest-only loan.
Who can apply for an interest-only mortgage?
The requirements for obtaining such a mortgage are quite strict. Why is this happening? Rates and housing prices are increasing, so an interest-only loan applicant qualifies as a borrower for a 30-year mortgage.
So, what you need to qualify for an interest-only mortgage loan:
- FICO score above 700
- Debt to income ratio below 36%
- Initial payment of 15%
- High income and assets
Benefits of an interest-only loan
Low down payment
As we wrote above, you pay both interest and principal in a conventional mortgage. But in an interest-only loan, your monthly payment will be lower because you will only pay interest in the beginning. The time of the principal debt will come a little later.
Having money to invest
With a low monthly payment, you will have more investment income and rapid capital growth. Or, you can save money for a retirement account.
Possibility of reducing the monthly payment
You can lower the amortized charge if you make additional payments during the interest period. With a regular fixed-rate mortgage, your monthly payment always stays the same.
Mortgage interest can be deducted from your tax return. Therefore, such a mortgage offers significant tax savings at the stage of interest payments.
Disadvantages of an interest-only loan
Interest payments do not increase your capital
You won’t add capital to your home if you don’t make additional principal payments. Therefore, you cannot take out a loan secured by your own home.
No refinancing guarantee
If your home depreciates, this can lead to a lack of capital. Subsequently, this will become an obstacle to refinancing.
Payments will increase in the future
Interest-only loans will be converted to amortized loans — for example, 10 years after issuance. Therefore, be sure you understand the loan terms if you take a loan at interest.
More interest over the term of the loan
Yes, your initial payment will be less. But, surprise — the total amount of mortgage interest is higher.
Lenders will definitely have more requirements for the borrower’s down payment. Also, there will be a lot of attention to your credit score. You must also demonstrate that you can repay the loan even if the monthly payment increases.
Who is this option for?
Getting a loan only at interest will be a good option if:
- You plan to live in the house for a short time. It makes sense to take out a mortgage only at interest when you are ready to sell the house after the interest payment period has expired. Especially if house prices are rising in your area.
- You plan to rent the house or hold it as an investment property. This is a good way to reduce monthly mortgage costs for those who buy a home purely for rent.
- You want to invest and need more cash flow. The flexibility of low payments will help you increase your earnings.
- You will receive more at the time of depreciation. For example, you will have access to a retirement account, a new investment, or an inheritance at the end of the interest period.
An interest-only loan will be a bad option if:
- You need more time to be ready to pay the full monthly payment. In this case, interest will not save you — after all, you still have to pay the principal. You need to build a debt repayment budget based on what you earn today.
- You need more money to pay a high down payment, like 15%.
- You want to buy a home in an unpromising area where the cost of housing is falling. Then, expect difficulties with refinancing.
- Suppose your main goal is the least expenses during the loan term. In this case, you need a more profitable mortgage.
What other mortgage options are there?
A hybrid mortgage with an adjustable rate. The borrower receives a fixed rate initially and can secure a lower payment than a 30-year fixed-rate loan. The main disadvantage will come when the interest rate is converted into a regulated rate. And your costs will become unpredictable.
Conventional fixed-rate mortgage
Let’s say unpredictable payments are stressful for you, but you still want to save money. A good alternative would be a regular mortgage with a fixed interest rate. Loans with a term of 15-30 years are available, but their main disadvantage is the higher interest rates.
Try an FHA loan if you need more savings for a down payment or a low credit score. It features lower requirements, a 3.5% down payment, and a high debt-to-income ratio. Of the minuses – the need to pay mortgage insurance on the loan.
Interest-only mortgages are not just a way to save on monthly payments. For many, this is more of an investment opportunity. Whatever your goals, we are ready to help you achieve them. Contact LBC Mortgage to find the perfect financing for your plans. And, of course, get advice from a team of brokers with many years of experience. We are always happy to explain to you in simple terms how the complex world of mortgages works!