Interest-Only Mortgage: Definition, How They Work, Pros and Cons

May 18, 2023 By admin

interest-only loan example

The first advantage is that the monthly payments on an interest-only mortgage are initially lower than those of a conventional loan. Note that many interest-only mortgages are adjustable-rate mortgages, which have an APR that varies with the prime rate. So you may not have predictable fixed monthly payments with an interest-only home loan.

There were many types of subprime loans based on the interest-only model. Most of these were created after 2000 to feed the demand for subprime mortgages. Banks had started financing their loans with mortgage-backed securities. These derivatives became so popular they created a huge demand for the underlying mortgage asset.

interest-only loan example

The drawback is that once the interest rate converts to an adjustable rate, your payments can be unpredictable. The appeal of an interest-only mortgage is the lower initial payment, which you can stick with for as long as ten years before making any payments towards the principal. But you’ll pay more in overall interest — plus, since interest-only loans aren’t qualified mortgages, there can be stricter requirements to qualify. Interest-only mortgages are usually not suitable for typical long-term home buyers, including first-time buyers. Many homeowners got in trouble with interest-only loans during the housing crash in 2008. After their interest-only periods ended, they owed more on their homes than they were worth, and many couldn’t afford the higher principal-and-interest payments.

Advantages of Interest-Only Loans

“The home prices are going up, so they can take advantage of the capital appreciation that way,” he says. Interest-only payments may be made for a specified time period, may be given as an option, or may last throughout the duration of the loan. With some lenders, paying the interest exclusively may be a provision that is only available for certain borrowers. Unlike agency mortgages, there’s no strict set of minimum requirements to qualify for an interest-only mortgage.

An interest-only mortgage requires payments just of the interest — the cost of borrowing money — during the first years of the loan. After the interest-only period, you can refinance or pay off the loan or start making monthly payments of both principal and interest. With an interest-only loan, you pay only the interest on the loan, not the amount of the loan itself (also known as your “principal”). Eventually, you’re required to pay off the full loan either as a lump sum or with higher monthly payments that include principal and interest. Most interest-only mortgages require only the interest payments for a specified time period—typically five, seven, or 10 years.

The down payment, debt-to-income (DTI) ratio and credit score you will need are entirely up to the lender. An interest-only mortgage can make it more affordable to own a home for a few years. Since it initially doesn’t require you to make payments toward the principal, your monthly payment will be less. An interest-only mortgage is a type of mortgage in which the mortgagor (the borrower) is required to pay only the interest on the loan for a certain period.

Dallal concurs that “the larger big name banks have higher down payment requirements,” but notes that alternative lenders like MBANC typically will lend up to 85% of the value of the home. Still, borrowers would need more savings than they would for a government-backed mortgage. An interest-only mortgage (IO mortgage) is a home loan that allows you to make only interest payments for an initial period. Following that period, you can either refinance, pay the remaining balance in a lump sum or begin making regular monthly payments. Here’s everything you need to know about how they work and how you can qualify. Interest-only mortgages reduce the required monthly payment for a mortgage borrower by excluding the principal portion from a payment.

interest-only loan example

That way, they don’t notice a difference in their standard of living. If they lose their jobs or have unexpected medical costs, they can go back to paying just the interest amount. That makes an interest-only loan superior to a conventional mortgage for disciplined money managers. The lenders that still offer interest-only mortgages tend to the hold them in their own portfolios or sell them to certain investors with an appetite for such risk.

You may have to shop multiple lender websites to get a general idea of rates. It’s also important to note that if you don’t pay any principal, you don’t accumulate equity, unless the market value of your home goes up. But these mortgages have stricter qualifications than typical principal-and-interest loans, and they’re appropriate for only a narrow range of homeowning scenarios. Our partners cannot pay us to guarantee favorable reviews of their products or services.

What is an interest-only mortgage?

Our affordable lending options, including FHA loans and VA loans, help make homeownership possible. Check out our affordability calculator, and look for homebuyer grants in your area. Visit our mortgage education center for helpful tips and information. And from applying for a loan to managing your mortgage, Chase MyHome has you covered. An interest-only loan is an adjustable-rate mortgage that allows the borrower to pay just the interest rate for the first few years.

  1. Most of these were created after 2000 to feed the demand for subprime mortgages.
  2. For first-time home buyers, an interest-only mortgage also allows them to defer large payments into future years when they expect their income to be higher.
  3. An interest-only mortgage allows you to pay just the interest and no principal with each monthly payment, usually for the first five, seven or 10 years of the loan term.
  4. For example, an interest-only mortgage could be a good fit for someone who earns large annual bonuses at work and uses those to pay down the principal.

In some cases, the borrower may have to pay only interest for the entire term of the loan, which requires them to manage accordingly for a one-time lump sum payment. An interest-only mortgage is generally best suited to a buyer in a strong financial position who plans to own the property for a limited time, such as five to 10 years. These business transaction definition loans can also work for people who want flexibility and have the financial discipline to make periodic principal payments during the interest-only period. With most loans, your monthly payments go toward both your interest costs and your loan balance. Over time, you keep up with interest charges and gradually eliminate the debt owed.

Interest-only home loan

The bank would only offer a refinance on the new, lower equity value. Homeowners that couldn’t afford the increased payment were forced to default on the mortgage. Interest-only loans were a big reason so many people lost their homes. That only works if the borrower plans to make the higher payments after the introductory period. For example, some increase their income before the intro period is over. The remaining borrowers refinance to a new interest-only loan, but that doesn’t work if interest rates have risen.

That introductory period typically lasts between three to 10 years. The interest rate may increase and the monthly payment must also cover some of the principal. Some interest-only mortgages require the borrower to pay off the entire balance after the introductory period. If the idea of unpredictable payments causes you stress, or if you want to save money over the life of your home loan, a conventional fixed-rate mortgage is a good alternative. When you apply for a conventional fixed-rate mortgage, you’ll lock in your APR and your monthly payments will remain the same over the entire term.

The qualifications for these loans aren’t standardized and can vary widely from lender to lender. Most house flipping loans are interest-only to maximize the money available for making improvements. With an interest-only loan, your loan payments are only enough to cover the loan’s interest. This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data.

How do interest-only mortgages work?

And they may have better uses for their money during the interest-only period that they come out ahead in the long run. Those other uses may come with additional risk that the average homeowner can’t afford to take on, however. As with any mortgage, you can expect to pay a rate in proportion with the loan’s risk. And you will likely get the best rate by shopping around to get quotes from several lenders that’s more specific to your price point and credit profile. You can also expect to pay all the usual closing costs, like an origination fee, title insurance premium and appraisal fee. An interest-only mortgage allows you to pay just the interest and no principal with each monthly payment, usually for the first five, seven or 10 years of the loan term.