Page‹
Downside of an Interest Only Mortgage
Interest only mortgages can entice borrowers for several reasons including a lower initial monthly payment because you are not paying principal, the opportunity to qualify for a higher loan amount and the flexibility to pay down principal on your own schedule, at least initially. Interest only mortgages are well suited for borrowers who want a more flexible financing option, for borrowers who are going to sell their home or pay off their loan before the interest only period ends and for borrowers who have higher appetites for risk.
It is important that interest only mortgage borrowers are comfortable with risk because the downside of an interest only mortgage is significant. With an interest only loan, the borrower pays a lower interest only payment during the the first three, five, seven or ten years, and then is required to pay both principal and interest for the remainder of the loan. During this period, also called the adjustable rate period, your mortgage rate and monthly payment can potentially increase significantly.
For example, with a 10/1 interest only mortgage, your rate is fixed for the first ten years and then subject to change and potentially increase annually or semi-annually for the final 20 years of the loan. Your payment increases when you start paying principal plus your mortgage rate can go up which would cause your payment to increase even more. Economic factors could cause a jump in mortgage rates that results in your monthly payment suddenly spiking.
Additionally, because you did not pay down any principal during the interest only period, you pay the mortgage balance back over a shorter period of time, which also increases your monthly payment. For example, with a 10/1 interest only loan you pay back the entire mortgage balance in 20 years instead of 30. So there are multiple factors that can potentially contribute to a payment spike which is the downside of an interest only mortgage.
A significant increase in your monthly mortgage payment can come as a shock, especially for borrowers who lack financial flexibility or who have limited savings. Depending on your loan amount, the interest rate environment and your mortgage terms, the monthly payment for an interest only loan can potentially increase thousands of dollars. If you cannot pay your mortgage you could be subject to penalties, default and eventually foreclosure.
In fact, during the real estate crisis many borrowers with interest only mortgages could not afford their higher payments and lost their homes to foreclosure. Although this is the most severe outcome, you should be aware of the serious downside of an interest only mortgage. Borrowers who are initially attracted to the lower payment of an interest only mortgage may find themselves financially stretched later in the future.
The lender table below compare mortgage rates and fees for interest only loans. The rate and monthly payment for an interest only mortgage can jump over your loan term and may be much higher than the figures shown in the table. If you are comfortable with the possibility of payment shock and other interest only mortgage risks, we recommend that you compare loan proposals from multiple lenders to find the best mortgage terms.
A major spike in your mortgage payment can be highly challenging so you should understand both the best and worst case outcomes for an interest only mortgage to make sure that it matches your risk appetite and financial goals. The example below demonstrates the downside of an interest only mortgage to enable borrowers to make an informed decision when they select their loan program.
In short, the risk of an interest only mortgage is the possibility that your mortgage rate and payment jump during the adjustable rate period. For example, if interest rates increase at the same time you are required to start paying principal this could cause your monthly payment to spike significantly. Depending on your mortgage terms and the market environment, this could occur in year eight of the mortgage or 18, which highlights the uncertainty of an interest only loan. It is simply impossible to know when and by how much your mortgage rate and monthly payment will jump.
- OurINTEREST ONLY MORTGAGE CALCULATOR shows you the worst case scenario for any interest only mortgage
One way to the demonstrate downside of an interest only mortgage is to look at the worst case scenario. The example below illustrates the risks of an interest only mortgage by comparing the worst case scenario for a 7/1 interest only mortgage to a 30 year fixed rate mortgage and 7/1 adjustable rate mortgage (ARM). The example is based on these assumptions:
The chart below compares the monthly mortgage payment and total interest expense for an interest only mortgage (blue line), fixed rate mortgage (red line) and ARM (green line) over the course of the three mortgages. We summarize the key terms for each mortgage below:
- 7/1 Interest Only Mortgage: The interest rate and monthly payment are fixed for the first seven years of the loan (interest only period), during which the borrower pays only interest and no principal, and then are subject to change and increase in year eight for the remaining 23 years of the loan (adjustable rate period). The interest only period interest rate is 3.000%. According to this example, the interest only mortgage reaches its maximum interest rate of 8.000%, based on adding the life cap (5.000%) to the interest only period rate (3.000%), in year eight -- as quickly as possible -- and remains at the level for the remainder of the loan.
- Fixed Rate Mortgage: Fixed 4.000% interest rate over the 30 year term of the mortgage. The rate and monthly payment do not change over the course of the loan.
- 7/1 Adjustable Rate Mortgage (ARM): The interest rate and monthly payment are fixed for the first seven years of the loan (fixed rate period) and then subject to change and increase in year eight for the remaining 23 years of the loan (adjustable rate period). The fixed rate period interest rate is 2.750%. According to this example, the ARM reaches its maximum interest rate of 7.750%, based on adding the life cap (5.000%) to the fixed rate period rate (2.750%), in year eight and remains at the level for the remainder of the loan.
As illustrated by the chart below, during the first seven years, the interest only period, the monthly payment of $950 for the interest only mortgage is lower than the $1,551 payment for the ARM and $1,814 payment for the fixed rate mortgage. Beginning in year eight, the monthly payment for both the interest only mortgage and ARM increase significantly as the interest rate for the interest only mortgage jumps from 3.000% to 8.000% and the rate for the ARM jumps from 2.750% to 7.750%, the maximum possible increase at the first adjustment period for both loans. The rate for the interest only mortgage stays at 8.000% and the rate for the ARM stays at 7.750% for the remaining 23 years of the loans.
Also beginning in year eight, the monthly payment for the interest only mortgage increases significantly to $3,015 as compared to $2,465 for the ARM and $1,814 for the fixed rate mortgage, which stays constant. The monthly mortgage payment for the interest only mortgage is greater than the payment for the ARM because of the higher mortgage rate and because the interest only mortgage starts to amortize so the payment includes both principal and interest.
According to this example, the interest only mortgage requires $258,900 more in interest expense over the life of the mortgage as compared to the fixed rate mortgage and $101,316 more in interest expense as compared to the ARM. Although this example is unlikely and represents the absolute worst case scenario, it effectively illustrates the downside of an interest only mortgage.
Review our interest only mortgage instructional video to understand key program negatives and risks.
Sources
"What are the risks with I-O mortgage payments and payment-option ARMs?" FDIC. Federal Deposit Insurance Corporation, October 31 2006. Web.
About the author