Mortgage Rates
Refinance Rates
FHA Rates
VA Rates
Jumbo Rates
Adjustable Rate Mortgage Rates
Interest Only Mortgage Rates
Non-Owner Occupied Rates
Home Equity Loan Rates
Downside of an Interest Only Mortgage

Downside of an Interest Only Mortgage

Michael Jensen, Mortgage and Finance Guru
, Mortgage and Finance Guru

    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.

  • %
    Current Interest Only Mortgage Rates as of March 26, 2019
    • Lender
    • APR
    • Loan Type
    • Rate
    • Payment
    • Fees
    • Contact
    View All Lenders

    %

    Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. Click for more information on rates and product details.
  • 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.

  • Example: Worst Case Scenario for an Interest Only Mortgage
  • 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.

  • Use our INTEREST ONLY MORTGAGE CALCULATOR to review 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:

  • Key Assumptions

    7/1 Interest Only Adjustable Rate Mortgage (ARM)

    Mortgage amount $380,000 Index 1 Year LIBOR
    Mortgage term 30 years Margin 2.250%
    Interest only period 7 years Initial adjustment cap 5.000%
    Interest only period rate 3.000% Subsequent adjustment cap 2.000%
    Adjustment period Annual Life cap 5.000%

    30 Year Fixed Rate Mortgage

    Mortgage amount $380,000
    Mortgage term 30 years
    Interest rate 4.000%

    7/1 Adjustable Rate Mortgage (ARM)

    Mortgage amount $380,000 Index 1 Year LIBOR
    Mortgage term 30 years Margin 2.250%
    Fixed rate period 7 years Initial adjustment cap 5.000%
    Fixed period interest rate 2.750% Subsequent adjustment cap 2.000%
    Adjustment period Annual Life cap 5.000%
  • 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.

  • Monthly Mortgage Payment
    • 7/1 Interest Only ARM
    • Fixed Rate Mortgage
    • 7/1 ARM
    $3,200 $2,800 $2,400 $2,000 $1,600 $1,200 $800 $400

    Interest Only Adjustable Rate Period

    Interest Rate: 8.000% Monthly Payment: $3,015

    ARM Adjustable Rate Period

    Interest Rate: 7.750% Monthly Payment: $2,465
     

    Fixed Rate Mortgage

    Interest Rate: 4.000% Monthly Payment: $1,814

    Total Interest Expense

    Interest Only: $531,940 ARM: $430,624 Fixed Rate Mortgage: $273,040

    ARM Fixed Rate Period

    Interest Rate: 2.750% Monthly Payment: $1,551

    Interest Only Period

    Interest Rate: 3.000% Monthly Payment: $950
    • Year 1
    • Year 2
    • Year 3
    • Year 4
    • Year 5
    • Year 6
    • Year 7
    • Year 8
    • Year 9
    • Year 10
    • Year 11
    • Year 12
    • Year 13
    • Year 14
    • Year 15
    • Year 16
    • Year 17
    • Year 18
    • Year 19
    • Year 20
    • Year 21
    • Year 22
    • Year 23
    • Year 24
    • Year 25
    • Year 26
    • Year 27
    • Year 28
    • Year 29
    • Year 30
  • Review our interest only mortgage instructional video to understand key program negatives and risks.

  • FREEandCLEAR Mortgage Instructional Video

    How Interest Only Mortgages Work Instructional Video

  • Sources

    Interest Only Mortgage Risks: https://www.fdic.gov/consumers/consumer/interest-only/index.html#risks

About the author

Michael Jensen, Mortgage and Finance Guru

Michael is the co-founder of FREEandCLEAR. Michael possesses extensive knowledge about mortgages and finance and has been writing about mortgages for nearly a decade. His work has been featured in leading national and industry publications. More about Michael

X

Get Free Personalized Mortgage Quotes

First Name:
Last Name:
Phone Number:
Email:

My Mortgage Info

Mortgage Type
Credit Score
Loan Amount
Property Value
City
State
GET FREE Quotes
FREEandCLEAR.comThank you for submitting your information!
FREEandCLEAR.comYour mortgage quote request has been sent to our lending partners and you should receive emails from multiple lenders shortly
FREEandCLEAR.comComparing proposals from multiple lenders is the best way to save money on your mortgage!