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How does an interest-only mortgage work?

Yahoo Personal Finance· Getty Images
Updated 5 min read

There are two parts to a traditional home loan payment: the mortgage principal and the mortgage interest. But if you have an interest-only mortgage, you only have to make interest payments for the first few years of the loan. Once the interest-only period has lapsed with an interest-only loan, you will be required to make payments toward both the principal and interest each month.

Here’s what you need to know about how interest-only mortgages work.

Read more: Types of mortgage loans

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An interest-only mortgage is a type of balloon loan. In most cases, an interest-only mortgage loan is set up as an adjustable-rate mortgage (ARM), meaning the interest rate you pay on your loan can fluctuate. The option of making interest-only mortgage payments will generally last between three and 10 years. After the interest-only payment period ends, you will then have to make principal and interest payments, which means your monthly payment will increase, regardless of whether the interest rate stays the same or changes.

For example, you might have a mortgage with a 30-year loan term that has a 10-year interest-only period. You’d make interest payments for the first decade, then pay down your principal and interest for the remaining 20 years.

Learn more: Use Yahoo Finance’s free mortgage calculator

There are several reasons why a home buyer might choose an interest-only mortgage. To start, the initial monthly mortgage payments on these loans are lower. This could help you afford your mortgage payments for a few years until you’re ready to start paying down the principal.

In addition, the interest-only period usually does not prohibit you from making principal payments. Any principal payments you make during this initial interest-only term will not only help you build equity and pay off your mortgage faster, but they can also lower your monthly payments. That’s because your extra payments toward the principal reduce the total amount you owe, which reduces how much you owe in monthly interest payments.

This is different than paying extra on a regular mortgage loan. While making extra principal payments with a traditional home loan will help you pay off the mortgage faster and pay less in interest over the years, it will have no impact on your monthly payment amount.

In many cases, interest-only mortgages may also offer lower initial interest rates than fixed-rate mortgages. These types of loans have adjustable rates, which typically start lower than fixed rates. This can make payments more affordable — at least in the beginning. You risk your rate increasing if market rates go up. On the bright side, your rate could go down if market rates decrease.

Finally, choosing an interest-only mortgage may allow you to afford a more expensive house since interest-only payments are much easier to afford than traditional mortgage payments. This can be a big benefit to anyone who either does not plan to stay in the house for the long haul or expects a major income boost in the coming years.

Read more: Adjustable-rate vs. fixed-rate mortgage

Although interest-only mortgages may initially be more affordable, there are several major risks associated with these types of loans.

For example, you will not build equity for the first few years of an interest-only mortgage. Other than the down payment, you will have no equity in the home, which could cause serious financial problems when you sell the house.

If you sell the home before the end of the interest-only period, you will not be able to make a profit on the sale of the house — unless the home’s value has increased significantly. Alternatively, if the home value goes down before you have made any principal payments, you could experience negative amortization and owe money to your mortgage lender if you sell before the end of the interest-only period.

Additionally, the increased monthly payments after the end of the interest-only period may be unaffordable, especially if your income has not changed in that time. Taking out an interest-only mortgage based on your belief that your income will rise could lead to an unpleasant financial surprise.

Even though interest-only loans often have lower interest rates than fixed-rate mortgages, the rates on these types of loans tend to be adjustable. That means they may increase (depending on which direction market rates are moving), giving you a larger monthly payment during the interest-only period — all without building any equity.

Finally, some interest-only mortgages require the borrower to pay off the outstanding principal in one lump sum after the end of the initial payment period. If you are considering an interest-only loan, make sure you fully understand the mortgage lender’s repayment terms.

Learn more: Best mortgage lenders for first-time home buyers

In general, interest-only mortgages are best suited for home buyers who do not plan to stay in the house longer than the initial interest-only payment period or those who anticipate a major cash flow increase in the coming years. In either case, a home buyer should feel very confident about either their plans to sell the home or their ability to command a higher salary before the end of the interest-only term. For this reason, home flippers often take out interest-only mortgages for the houses they are renovating and selling.

While each lender will have its own rules for interest-only mortgage lending, you should expect to make a substantial down payment and meet stricter eligibility requirements. In general, mortgage lenders will require at least a 20% down payment and want to see a good credit score and low debt-to-income ratio.

The typical interest-only repayment period lasts from three to 10 years. These lower monthly payments will increase after the end of the interest-only period since your mortgage payment will now include principal payments in addition to interest payments.

This article was edited by Laura Grace Tarpley