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How an Interest Only Mortgage Works
Given its name, you may think it is easy to understand how an interest only mortgage works but it is more complicated than that. In short, with an interest only mortgage borrowers pay interest and no principal but only for part of the loan. During the interest only period of the loan, which is usually the first three, five, seven or ten years, you pay only interest. Because the borrower is not required to pay principal, the monthly payments during the interest only period are lower than the payment for an amortizing loan such as a fixed rate mortgage or an adjustable rate mortgage (ARM). The lower initial monthly mortgage payment and corresponding ability to afford a higher loan amount are two of the main attractions of an interest only mortgage. Borrowers also have the option to pay down principal during this initial period if they want to which provides added financial flexibility.
The loan gets a little more complicated and more expensive, however, when the interest only period ends. This is why it can be challenging to understand how an interest only mortgage works for the entire loan term. After the interest only period, the mortgage starts to amortize and the borrower pays both principal and interest for the remainder of the loan. This second part of the loan is called the adjustable rate or amortization period because you are required to pay principal and your mortgage rate is also subject to change. Your monthly mortgage payment increases when you start paying principal, plus your payment can increase even more if interest rates go up. A significant and sudden spike in your monthly payment during the adjustable rate period is the biggest risk of an interest only mortgage.
- OurINTEREST ONLY MORTGAGE CALCULATOR shows you the monthly payment for an interest only loan
Interest only loans are usually called 3/1, 5/1 , 7/1 and 10/1 interest only ARMs, or IO ARMs for short, because they are part interest only loan and part adjustable rate mortgage (ARM). Interest only mortgages typically have 30 year terms. For example, with a 5/1 interest only mortgage, your monthly payment is comprised of only interest for the first five years and then the payment is comprised of both interest and principal for the remaining 25 years, plus the interest rate changes annually for the duration of the loan. Some interest only loans adjust semi-annually or monthly following the interest only period.
An interest only mortgage exposes you to the risk that your interest rate and mortgage payment will increase significantly over the life of the loan. The risk of an increase in monthly mortgage payment with an interest only mortgage is greater than with other types of mortgages such as a fixed rate mortgage or ARM because you have not paid down any principal during the initial interest only period.
Interest only mortgages are complex and can be challenging to understand. Loan terms determine how an interest only mortgage works including when you are required to start paying principal and when your interest rate and monthly payment can change. We outline the important interest only loan terms below. Knowing these terms enables borrowers understand the mechanics of an interest only mortgage.
Interest Only Period Interest Rate
Interest rate pricing for the initial interest only period is set by the lender and is typically lower than the prevailing interest rate for a 30 year fixed rate mortgage but slightly higher than the initial fixed period interest rate for an ARM. The monthly monthly mortgage payment during the interest only period is lower than the payment for a fixed rate mortgage or ARM because you are only paying interest and no principal. The lower initial interest rate and monthly mortgage payment are the primary reasons to select an interest only mortgage.
Fully-Indexed Rate for an Interest Only Mortgage
The interest rate for the adjustable rate period, which follows the interest only period, is called the fully-indexed rate. The fully-indexed rate is calculated by adding the index to the margin. The index is an underlying rate that change based on the shift in the economy. Interest only mortgages issued after June 2020 typically use the 30 day average SOFR as the index and loans issued before June 2020 usually use LIBOR. The margin is a set interest rate amount that does not change over the term of the loan. The margin is typically 2.000% - 3.000%. So if SOFR is 1.500% and the margin is 2.000% then the fully-indexed rate is 3.500%.
The fully-indexed rate is recalculated on an annual, semi-annual or monthly basis for the remainder of the mortgage term following the interest only period and changes with any fluctuations in the index. So in the case of a 5/1 interest only mortgage, the fully-indexed rate adjusts on an annual basis for the final 25 years of the loan.
Adjustment Caps for an Interest Only Mortgage
Interest only mortgages have an initial adjustment cap that limits the change in your mortgage rate when the loan first adjusts. The initial adjustment cap is typically 2.0% or 5.0%. Interest only mortgages have a subsequent adjustment cap that limits the change in mortgage rate in any adjustment period following the initial adjustment. Interest only mortgages also have a life cap which limits the maximum increase in interest rate over the term of the mortgage. The typical life cap for an interest only mortgage is 5.0% which means the fully indexed rate cannot exceed the initial interest only interest rate by more than 5.0%. For example, if your interest only period rate is 3.750% and the life cap is 5.000%, then the maximum mortgage rate is 8.750%.
The table below summarizes the key loan terms to focus on in evaluating an evaluating an interest only mortgage. Knowing these loan terms helps you understand everything there is to know about an interest only mortgage.
The rate you pay on an interest only mortgage depends on several factors including your credit score, loan-to-value (LTV) ratio, mortgage type and loan term. Additionally, interest only mortgage rates tend to be lower than the interest rate for a fixed rate mortgage but slightly higher than the interest rate for an ARM. Interest only mortgages are provided by traditional lenders such as banks, mortgage banks, mortgage brokers and credit unions.
The lender table below shows mortgage rates and fees for interest only lenders near you. As the table shows, the shorter the interest only period, the lower the rate. Additionally, the table also demonstrates the wider range in loan terms across different lenders that you typically see with interest only mortgages. You should shop multiple lenders to find the interest only mortgage with the lowest interest rate and fees.
During the real estate market bubble many borrowers got into trouble with interest only mortgages because they could not afford the mortgage payment when it increased. Many of these borrowers defaulted on their mortgages and lost their homes due to foreclosure which caused most lenders to stop offering interest only mortgage programs. Additionally, government regulations changed which also made it more challenging for lenders to offer interest only mortgages.
- Review Downside of an Interest Only Mortgage to understand the risks of an interest only loan
As the real estate and mortgage markets have recovered more lenders have gradually started offering interest only mortgages again. Because of the risk involved with interest only mortgages lenders now typically have tougher borrower qualification requirements for this type of mortgage. Lenders may require higher credit scores (above 720) and in some cases lower loan-to-value (LTV) ratios (80.0% or below). This means you usually are required to make a down payment of at least 20% to qualify for an interest only mortgage. Not all lenders offer interest only loans so you may need to shop around to find a lender that does. It is also important to understand a lender's specific borrower qualification requirements for an interest only mortgage as they are likely different than the requirements for other mortgage programs.
Use the
FREEandCLEAR Lender Directory
to find lenders in your state that offer interest only mortgages and twenty-four other loan programs.
The monthly payment for an interest only mortgage changes significantly over the course of the loan. For the first several years, the interest only period, the monthly payment is lower than the payment for a fixed rate mortgage or ARM because you do not pay principal. Because you pay no principal, you still owe the entire loan amount when the loan starts to amortize. For example, for a $380,000 7/1 interest only loan, you owe $380,000 at the beginning of year eight of the mortgage. This is different than a fixed rate mortgage or ARM where you pay down principal throughout the entire loan term.
The mortgage payment increases at the beginning of the amortization period -- also known as the adjustable rate period -- because you are required to pay both interest and principal plus you have to repay the full loan amount over a shorter period of time, which also increases the payment. For example, with a 30 year fixed rate mortgage, you repay the loan balance over 30 years. With a 7/1 interest only mortgage, you repay the fully loan balance over the final 23 years of the loan. Repaying a mortgage over a shorter period of time results in a higher monthly payment.
The example below demonstrates how monthly payments for an interest only mortgage can change and increase. The example compares a 7/1 interest only mortgage (red line) to a 30 year fixed rate mortgage (blue line) with a 4.000% interest rate. Both mortgages in the example are $380,000 with 30 year terms. For the interest only mortgage, the rate for the interest only period (first seven years) is 3.000% and the rate is held at 4.000% -- the same as the fixed rate mortgage -- throughout the remaining 23 years (adjustable rate period). Although having a constant interest rate throughout the adjustable rate period for an interest only loan is an unlikely scenario, it helps illustrate the differences in how the two programs work.
During the interest only period, the $950 monthly payment for the interest only mortgage is lower than the $1,814 monthly payment for the fixed rate mortgage. In year eight, the monthly payment for the interest only loan increases significantly from $950 to $2,108 and is greater than the payment for the fixed rate mortgage for the remainder of the term even though both loans have the same 4.000% interest rate. The spike in payment is because in year eight the rate for the interest only loan increases from 3.000% to 4.000%, the borrower is required to start paying principal plus the entire loan balance must be repaid over shorter period of time -- 23 years.
This example shows only one scenario and it is impossible to predict how interest rates will change in the future but it provides a helpful framework to understand how an interest only mortgage works.
The main reason a borrower selects an interest only mortgage is because the monthly payment during the initial interest only period is lower than the monthly payment for an amortizing loan such as a fixed rate mortgage or an ARM. So if you know that you are only going to own the property for a shorter period of time, then an interest only mortgage may be the right program for you. That way you benefit from the lower monthly mortgage payment during the initial interest only period but you are not exposed to a potential spike in monthly payment when the loan amortizes. Additionally, you can typically qualify for a larger mortgage amount with an interest only mortgage because the initial monthly payment is lower. With an interest only mortgage, however, you do not pay down your loan balance during the initial period and therefore build no equity in your house unless the value of your property appreciates or you overpay your loan.
The chart below compares the monthly mortgage payments for a $380,000 mortgage for 3/1, 5/1, 7/1 and 10/1 interest only mortgages; 3/1, 5/1 , 7/1 and 10/1 ARMs; and, a 30 year fixed rate mortgage. As the chart illustrates, in comparison to both a fixed rate mortgage and an ARM, an interest only mortgage allows borrowers to save money on their monthly payment during the initial period of the loan. Please note that for the 3/1, 5/1, 7/1 and 10/1 interest only mortgages and ARMs, the chart shows the initial monthly payment. Both the mortgage rate and payment are subject to change and may increase significantly over the course of both loans.
Another reason to choose an interest only mortgage is if you think that interest rates are going to decline in the future. If rates drop during the amortization period of your loan then your monthly payment may also go down, although it is usually higher than your initial payment because the payment includes both principal and interest. Predicting mortgage rates can be very challenging, especially over 30 years, so this approach leaves the borrower vulnerable to significant risk.
The final reason to choose an interest only mortgage is because it gives you flexibility over when and by how much you pay down the principal of your loan. You can always pay more than the required monthly payment which reduces your principal balance. For example, if a significant portion of your income comes from an annual bonus then an interest only mortgage may be ideal because you make lower monthly payments over the course of the year and then use your bonus to pay down principal.
The length of the interest only period directly affects your mortgage rate. The shorter the interest only period, the lower the rate and the lower your monthly payment. The trade-off of a shorter interest only period and lower rate is that the adjustable rate period is longer, which exposes you to more risk that your rate and payment increase and remain higher for a longer period of time.
The chart below demonstrates the relationship between the interest only period and your mortgage rate. The 3/1 interest only loan has the lowest initial rate while the 10/1 mortgage has the highest rate.
Sources
"Interest-Only Mortgage Payments and Payment-Option ARMs." FDIC. Federal Deposit Insurance Corporation, October 31 2006. Web.