Pros and Cons of an Interest Only Mortgage

Mortgage payments are typically the largest monthly expense for a homeowner. For a homeowner who needs help managing their income and expenses, a monthly mortgage payment can create significant difficulties with cash flow. Thankfully, there is a solution to this problem in the form of an interest only mortgage.

Pros of an Interest Only Mortgage

• Lower initial interest rate
• Lower monthly payment during interest-only period
• Can help you get into a more expensive home
• Potential for increased cash flow
• Potential for lower rates

Cons of an Interest Only Mortgage

• Not earning equity during interest-free period
• Risk losing equity if home values drop
• Lower payments are only temporary
• Interest rates can increase

For many homeowners, a mortgage payment is made up of several parts, which is why it’s often called a PITI payment: principal, interest, taxes, and insurance. Although these things could all be paid separately (at least the taxes and homeowner’s insurance), they are often bundled together for convenience. 

Let’s set aside the taxes and insurance for a moment and focus on the home loan itself. When you first start paying your mortgage, at least 50% of that payment will go toward the interest. But as you pay down the balance and the principal shrinks, the interest payments will shrink as well. Since their combined total will still yield a locked-in monthly minimum payment, this means a larger portion of the payment will go toward the principal. The point at which this happens is called the tipping point.

What Is an Interest Only Mortgage?

An interest only mortgage is a unique type of home loan where the borrower only makes interest payments for a certain time period. The principal borrowed amount is eventually paid at a later date, sometimes as a lump sum, and sometimes in installments. During the time period during which only interest payments are made, the loan terms are significantly favorable to the borrower. 

To make up for this disparity, the vast majority of interest only mortgages are set up as an adjustable rate mortgage or ARM. An adjustable rate mortgage has an interest rate that changes in accordance with certain financial indexes that vary from lender to lender. To make a long story short, that means the interest rate could go up. Although it may sometimes go down, it is more likely for the rate to increase, which of course means more profit for the lender. However, a homeowner who plans ahead can be prepared for this eventuality and refinance the mortgage with a new lender, or sell their home before the payments increase.

How To Qualify for an Interest Only Mortgage

An interest only mortgage can be difficult to obtain. Borrowers with significant amounts of money in their savings account, a high credit score, and a low debt to income ratio will have an easier time securing an interest only mortgage. One might say this is typical of the ironies surrounding loans and credit – those who need the most favorable terms find it hardest to get them. However, it is really not such an irony because loans are awarded based on credit history and the overall state of how you have managed your personal finances.

Here are some ways to have an easier time qualifying for an interest only loan: 

• FICO score of at least 700
• Debt to income ratio of 35% or lower
• Down payment of at least 15% (and 20% is even better)
• Indication of sufficient assets to indicate that paying down the principal balance will not be a problem once the mortgage term exits the interest only phase

Homebuyers who would benefit from the lower loan payment afforded by this type of mortgage, but who can’t meet these qualifications, often wonder how to get a mortgage. In this case, they may still be able to get the loan amount they need by looking at something like an FHA loan.

Pros of an Interest Only Mortgage

Interest only mortgages offer several benefits in the right situations. Let’s take a look at a few advantages of this type of home loan. 

Lower initial interest rate

This may not be the case for your interest only ARM, but many adjustable rate mortgages have a lower monthly interest rate when the loan begins, and for a certain amount of time. This is in part because the interest rate may (and probably will) increase after the adjustment period.

Lower monthly payment during interest-only period

This is the main benefit of an interest only mortgage. Although the interest only time period varies from lender to lender, it is typically going to be under ten years. During this time, the borrower will have a significantly lower monthly payment, because they won’t be paying money toward the principal. However, keep in mind, that you will still have to pay taxes and homeowner’s insurance. You should also keep in mind that if your down payment is less than 20% of the home’s value, you are probably going to have to get private mortgage insurance (PMI). This is not an insurance policy protecting your home, but rather a policy protecting the lender’s mortgage in case you default, and you are responsible for paying the premiums.

Helps you get into a more expensive home

When a homebuyer applies for a home loan, the bank will look at the applicant’s debt to income ratio to assess how easy it is for the buyer to meet financial obligations to a potential lender. They will also assess a projection of how a monthly mortgage payment will affect that ratio. An expensive home may be bumped out of a homebuyer’s purchasing power. But an interest only mortgage may make this purchase more possible.

Potential for increased cash flow

An interest only payment is going to be significantly lower than the monthly payment on a conventional mortgage. As residential mortgages typically tend to be the largest expense in consumer budgets, this can mean increased cash flow. If during the time of the loan term you have some other large expense you are paying for like college tuition or repayment of your own student loans, an interest only loan can make those other life goals financially feasible.

Potential for lower rates

An ARM loan does indeed present the risk of an increased mortgage rate. But if the rate is adjustable, sometimes the mortgage interest can actually go down. There are time periods when a fixed rate mortgage would result in a higher payment. For instance, during certain recessionary periods, key financial indices to which the rate of your mortgage is tied may drop, resulting in lower monthly payments. However, this pro can also be a con, so it should be discussed with a mortgage expert like your loan officer.

Cons of an Interest Only Mortgage

There are several disadvantages of an interest only mortgage. To best protect your investment, it’s important to be aware of the financial risks.

Not earning equity during interest-free period

Home equity is essentially how much you actually own of your home. That’s because until your mortgage is paid off, the home is collateral for the mortgage, and can be taken if you default on your payments. Every dollar put down toward the principal is a dollar toward actual free and clear ownership. With an interest only mortgage, you are not putting any money toward home equity during this time period. That can make it harder to qualify for something like a HELOC if you want a loan to do some renovations or remodeling.

Risk losing equity if home values drop

During the time period in which your payments are interest-only, you will not see any payments applied to the principal. This means that you will be a little bit behind other homeowners in terms of progressing toward full equity in your home. If the home’s value drops, even the equity you put into the home with your down payment may be canceled out. A reduction in home equity can make it difficult to refinance your home, which is one of the typical ways a homeowner can exit an interest-only mortgage. It can also make it difficult to get a home equity loan, which is something consumers typically use to fund home renovations or other big expenses.

Lower payments are only temporary

The lower payments of the interest only mortgage are only temporary. For many people, this means either increasing household income, refinancing the house, or selling it. While everyone hopes to increase their household income over time, and that does seem to be the natural course of events for some individuals in a set career path, nobody can guarantee that their income will increase over time. Refinancing is also a great option, but it depends on getting approved for a refi.

While selling your home can be a good exit strategy, it involves having to move. Additionally, if home values have declined, you will essentially be underwater and need your own cash to bridge the gap between the home’s sale and the outstanding loan balance.

Interest rates can increase

A mortgage calculator is supposed to give you a good idea of how your mortgage will pan out over the next 15 or 30 years. But when the terms of your mortgage loan change, that can change the picture as well. As interest only mortgages typically become ARM mortgages, that can put you in a situation where interest rates increase. If you have other debt like credit card debt or student loans, this can put a squeeze on your budget.

Who Should Get an Interest Only Mortgage?

The interest only mortgage is not for everyone. It typically works best for a homeowner who only plans to be in their residence for 5-10 years, and who would be selling the property anyway before the interest-only payment ends. Typical individuals who fall into this category are those who move frequently because of work or because of a spouse who works or is in the military. 

One type of homeowner who can do well with an interest only mortgage is someone who has the means and discipline to make periodic payments throughout the interest only period. An example of this might be a salesperson or sales manager who obtains significant bonuses and who can use them to bring down the balance with some voluntary extra payments.

Another type of homebuyer who fits well into this category is the retired individual or couple. They can use an interest only mortgage to finance a second home or vacation home. Before the interest only period expires, they can sell their primary residence and use that money to help settle the balance of their interest-only mortgage. Until then, they can retain that secondary residence and minimize the cost of its monthly mortgage payment.

Interest only mortgages are not good for first-time homebuyers or those buyers who plan to be in a home for a long time. This is because refinancing or increasing their income will be the only way they can repay the loan once it becomes an ARM mortgage. Many homeowners got in trouble in the 2008 recession because they had interest only mortgages. These first-time homebuyers should explore other types of mortgages that might be better suited to their life situation.

What Happens When the Interest Only Mortgage Ends?

When the interest only mortgage term ends, the interest payment will be accompanied by a principal payment as well, which can significantly drive up the entire amount of your monthly payment. 

For borrowers who have planned ahead, this might not pose a problem. For example, someone who needs to relocate every 5-10 years because of work will just sell their primary residence, pay off the mortgage, and finance a new home. Or, perhaps a doctor who was using the interest only mortgage to increase their cash flow during residency and medical school is now prepared to make those bigger payments because of their bigger paycheck. 

But what about those homeowners who cannot leave their homes for whatever reason, and who were unable to increase their cash flow, or had a plan to increase their cash flow but then life threw a wrench in their plans? These homeowners should have shopped around and consulted with the best mortgage lenders for a home loan that would fit better with how their life might pan out, such as a 30 year fixed rate mortgage. 

Remember – when shopping for a mortgage, you should work with the type of mortgage lender who takes the time to get to know you and your long term goals and aspirations over the next 30 years since an interest only mortgage may not be the right fit. Alternatively, if you plan on exiting your home or refinancing in 5-10 years, this type of home loan may be just the one for you.