Focus on the Interest Only Period. The length of the interest only period is one of the biggest factors that determines the initial rate for an interest only mortgage. The shorter the interest only period, the lower the starting rate and lower your initial monthly payment. For example, a loan with a three year interest only period should have a lower rate than a loan with a seven year period. The longer the interest only period, the more certainty you have regarding your mortgage rate and monthly payment but you pay a higher rate.
Know When the Loan Can Adjust. At the end the interest only period interest only loans effectively turn into adjustable rate mortgages (ARMs). This is why interest only mortgages are sometimes referred to as IO ARMs. Two important things change when an interest only mortgage adjusts. First, you start paying principal, which means your monthly payment usually increases. Second, your mortgage rate is subject to change and potentially increase which can cause your payment to go up even more. It is important to understand when an interest only mortgage can adjust so you can be prepared financially.
Interest Only Loans May Be Harder to Find. Because of their complexity and risk, interest only mortgages are not offered by all lenders. In fact, following the real estate crisis, interest only loans were very challenging to find. As the market has recovered, more lenders are offering the program but you may need to do some extra searching. Like with all loan programs, it is important to compare multiple proposals to find the lowest interest only mortgage rate and fees. Our lender table above can help you with the comparison process.
Understand the Qualification Requirements. Qualifying for an interest only mortgage is different than for other types of loans. Lenders have more discretion in setting the qualification requirements for interest only loans. For example, you are usually required to make a larger down payment and some lenders require a higher credit score to qualify. Like loan terms, qualification guidelines vary, so be sure to understand your lender’s requirements before you apply for the loan. It is also important to highlight that low down payment mortgage programs do not permit interest only loans.
With an interest only mortgage you pay only interest and no principal during the for the first 3, 5, 7 or 10 years of the loan, which is called the interest only period. Additionally, your interest rate is fixed and does not change during the interest only period. Plus, interest only mortgage rates tend to be lower than fixed mortgage rates, depending on the length of the interest only period. Because you are not paying principal during the interest only period, your monthly payment is lower than the payment for an amortizing loan such as a fixed rate mortgage or an adjustable rate mortgage (ARM), when the borrower pays both principal and interest. The flipside is that at the end of the interest only period, your payment increases because your are required to start paying both principal and interest for the remainder of the loan term, which is usually 30 years. Plus, your interest rate can potentially increase during this period of the loan which would cause your payment to go up even more.
The lower initial monthly payment provided by an interest only mortgage enables borrowers to afford a higher loan amount and buy more home. Being able to afford for a larger mortgage is one of the main benefits of an interest only mortgage. Borrowers who are enticed by the lower payment and higher mortgage amount offered by an interest only mortgage should also be aware of the possible payment shock in the future. Borrowers need to make sure that they can afford their monthly payment both at the beginning of the mortgage and over time when their payment is highly likely to increase.
An interest only mortgage enables borrowers to pay down principal based on their schedule as opposed to on a scheduled monthly basis like with a fixed rate mortgage or ARM. Borrowers can elect to pay down principal during the interest only period of the loan, even though they are not required to. When you pay down your principal mortgage balance during the interest only period, your required monthly payment also goes down. The flexibility to pay down principal when you want to makes interest only mortgages well suited for individuals who earn a modest monthly salary but a significant annual bonus. Borrowers in this position benefit from the lower monthly mortgage payments but can use a portion of their bonus to pay down their principal loan balance.
If you know that you are only going to own your home for the length of the interest only period, then an interest only mortgage may be the right option for you. That way you benefit from the lower monthly mortgage payment during the initial interest only period but you are not exposed to an increase in monthly payment and possibly interest rate at the end of the interest only period when the loan starts to amortize. Keep in mind that with an interest only mortgage, you do not pay down your loan balance during the interest only period and therefore build no equity in your home unless your property value increases.
Predicting what direction mortgage rates will go in the future is nearly impossible but if you are confident that rates are going to decline than an interest only mortgage may be a good option. If you are in the adjustable rate phase of an interest only loan when mortgage rates go down, then your monthly payment also declines. If you are in the interest only phase of the loan then changes in interest rates do not impact your payment. So if it interest rates are high it may actually be a good time to get an interest only mortgage because you take advantage of lower fixed payment initially along with the potential to benefit from lower rates in the future.
Interest only mortgage are the riskiest financing option for borrowers because your monthly payment can increase suddenly and significantly when the loan amortizes and you start paying principal. If interest rates also increase at the same time, your payment go up even more. This means that the possibility for payment shock is highest with an interest only mortgage. Borrowers should be comfortable with financial risk and be fully aware of both the positives and negatives before selecting an interest only mortgage.
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Interest only mortgages are the riskiest type of mortgage. Borrowers should review the risks of an interest only mortgage to make sure they understand the serious downsides
Review the pros and cons of the three main types of mortgages (fixed rate, adjustable rate (ARM) and interest only) to select the mortgage type that is right for you
“What is an "interest-only" loan?” CFPB. Consumer Financial Protection Bureau, February 22 2017. Web.