What is an Interest-Only Loan?
Interest-only mortgage loans have an initial period where the monthly payments consist of just the accrued interest, instead of payments towards your principal balance as well. Once the interest-only period ends, you begin to repay the loan on a regular amortization schedule — meaning that by the end of the loan term, your loan is repaid in full.
These aren’t the same interest-only loans that contributed to the housing crisis in the late 2000’s however. Even though these non-traditional loans are making a comeback, the riskiest features have been removed. For example, interest-only periods no longer end with a balloon payment due, and lenders won’t use the interest-only payment to qualify you for the loan.
Which Types of Lenders Offer Interest-Only Loans?
Nowadays, interest-only loans are being offered by banks, brokerages (via wholesale lenders), and direct lenders. Their products offerings include both fixed or adjustable interest rates programs, as well as jumbo mortgages and even loans with 40-year terms.
When it comes to conforming, conventional loans, Fannie Mae and Freddie Mac have discontinued purchases of interest-only loans (Freddie in 2010 and Fannie in 2014). This was due to the overall poor performance of these loans when property values dipped and many interest-only borrowers found themselves owing more than their homes were worth.
Currently, no government backed loan programs (FHA, VA, USDA) have interest-only features available. The low or even no down payment requirements for these loans, coupled with an interest-only feature could be a potential problem if property values were to decline during the interest-only period. So far, the government hasn’t been willing to take the risk.
What are the Benefits and Drawbacks of Interest-Only Loans?
You might be wondering, who would want an interest-only loan? Aren’t they going to pay more for their loan in the long-run? While interest-only loans aren’t for everyone, they are still a useful financial tool in specific situations.
- Improving cash flow with payment flexibility – Since you’re not required to make payments towards the principal balance of your loan during the interest-only period, you can use that money for other things, like investing, saving, or funding renovations and improvements. This is also useful if your income fluctuates seasonally, or based on commissions. You have the ability to make larger, lump-sum payments towards principal when your earnings allow for it, and can make interest-only payments in the interim.
- Reamortizing your loan with payments towards principal – Each time you make a payment towards the principal balance of your loan during the interest-only period, your future principal and interest payments are reduced because the loan is still amortized over the same remaining term (rather than being paid off sooner). If you wanted to reamortize or “recast” a traditional loan, lenders usually require a significant payment to principal and charge a recasting fee (sometimes as much as a few hundred dollars).
- Planning to sell your home before the interest-only period ends – If you’re planning on selling your home before the clock runs out on your interest-only period, it can help you to free up your cash flow and save up for a downpayment on your next home. In the event that you find a new home before selling your current one, an interest-only loan can help ease the burden of carrying two mortgages until your home sells.
There are drawbacks and disadvantages to interest-only loans as well. While these loans are less risky, thanks to increased industry regulation and tighter qualifying criteria, they still aren’t risk-free.
- You aren’t required to make principal payments — until you are. Since you’re not required to pay down the principal balance of your loan during the interest-only period, you won’t be building any equity in your property over that time. There’s always the possibility that home values could decrease, diminishing your equity stake overall.
- You can’t stretch your purchasing power with an interest-only loan. You won’t be able to qualify for a more expensive home by using an interest-only loan. On the contrary, you might actually qualify for less if the lender is using a shorter amortization period to calculate your future monthly payments. For more information, read section below on qualifying for an interest-only loan.
- You’re paying more interest over the life of the loan. During the interest-only period of your loan, you’re basically just renting the property you own — those payments aren’t going towards the principal obviously, so they’re just servicing the debt during that time. Consider this: after a number of years of interest-only payments, you still owe the entire principal balance plus interest during the repayment period. Check out our mortgage amortization calculator to figure out the difference.
How to Qualify for an Interest-Only Loan?
The qualification process for an interest-only loan is more complex than it is for principal and interest loans. You’ll still have to meet the usual income, asset, and credit qualifying criteria, but since lenders won’t qualify you based on the initial interest-only payment, they have to calculate your debt-to-income ratio based on the fully amortizing payments.
For example, if you want to get an interest-only 7/1 ARM, you’ll have to qualify for the monthly payments, based on the 23 year amortization period (30 year term – 7 year interest-only period = 23 years remaining). In order to ensure your ability to repay an interest-only ARM loan, lenders will often use an interest rate that is a few percentage points higher than your start-rate, or even the fully-indexed rate. There’s no way of knowing where the interest rates will be when your fixed rate period ends, so making sure you over-qualify is important when it comes to minimizing risky lending practices.
Bottom Line
Interest-only mortgages are back in the market, and it’s as important as ever to consider the pros and cons of this type of mortgage before you borrow. If the benefits outweigh the risks, and you’re confident in your ability to repay the loan under any market conditions, then it’s worth considering. For borrowers in volatile housing markets, with little equity or little experience when it comes to mortgages, it’s probably best to steer clear of interest-only loans.