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How an Interest Only Mortgage Works

How an Interest Only Mortgage Works

  • Interest Only Mortgage Overview
  • With an interest only mortgage, the borrower pays only interest and no principal during the initial interest only period, which is usually the first three, five, seven or ten years of the mortgage, and then the mortgages converts into an amortizing mortgage, typically an adjustable rate mortgage (ARM), when the borrower pays both principal and interest for the remainder of the mortgage term, which is called the adjustable rate period.  Because the borrower is not required to pay principal, the monthly mortgage payment during the interest only period is lower than the monthly payment for an amortizing loan such as a fixed rate mortgage or an ARM.  These mortgages are called 3/1, 5/1 , 7/1 and 10/1 interest only ARMs or IO ARMs for short. Interest only mortgages typically have 30 year terms. 

  • Great Mortgage IdeaA significant jump in interest rate and monthly payment is the biggest risk of an interest only mortgage
  • During the adjustable rate period the interest rate and monthly mortgage payment for an interest only mortgage can change annually or semi-annually (every six months) and potentially increase significantly.  For example, with a 3/1 interest only mortgage, the borrower's monthly payment is comprised of only interest for the first three years of the mortgage (interest only period) and then the payment is comprised of both interest and principal for the remaining 27 years of the mortgage (adjustable rate period), plus the interest rate is subject to change annually or semi-annually.  During the adjustable rate period, your mortgage payment typically increases because you start paying both principal and interest plus your interest rate can increase, which could cause your mortgage payment to go up even more.

  • CalculatorUse our INTEREST ONLY MORTGAGE CALCULATOR to calculate the monthly payment and worst case scenario for an interest only mortgage
  • 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 adjustable rate mortgage (ARM) because you have not paid down any principal during the initial interest only period.

  • FREEandCLEAR Mortgage Instructional Video

    How Interest Only Mortgages Work Instructional Video

  • 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 adjustable rate mortgage (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 can change. Lenders typically use the 1 year LIBOR as the index but be sure to confirm what index your lender uses. Simply put, LIBOR represents the interest rate that banks charge each other to borrow money and changes with fluctuations in the economy. The margin is a set interest rate amount that does not change over the term of the loan. The margin is typically 2.0% - 3.0%. So if the 1 year LIBOR is 1.000% and the margin is 2.250% then the fully-indexed rate is 3.250%.

    The fully-indexed rate is re-calculated on an annual or semi-annual basis for the remainder of the mortgage term following the interest only period and will change with any fluctuations in the index. So in the case of a 7/1 interest only mortgage, the fully-indexed rate adjusts on an annual basis for the final 23 years of the mortgage.

    Adjustment Caps for an Interest Only Mortgage

    Interest only mortgages have an initial adjustment cap that limits the change in the interest rate at the time of the first adjustment period.  The initial adjustment cap is typically 2.0% or 5.0%. Interest only mortgages have a subsequent adjustment cap that limits the change in interest 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 fixed period interest rate by more than 5.0%.

    Interest Only Mortgage Key Items

    The table below summarizes the key items to focus on in evaluating an evaluating an interest only mortgage.

  • Key Interest Only Mortgage Concepts
    Term
    • Indicates the length of the mortgage, presented in years
    • Interest only mortgages typically have a term of 30 years
    • A 30 year interest only mortgage has 360 monthly mortgage payments (12 payments per year * 30 years = 360 total monthly payments)
    • Monthly mortgage payments may change over the term of the mortgage
    Interest Only Period
    • Initial time period for an interest only mortgage during which the monthly payment is comprised of interest only
    • The interest only period is typically 3, 5, 7 or 10 years
    Interest Only Interest Rate
    • The interest rate for the initial initial only period
    • Fixed for the interest only period
    Adjustable Rate Period
    • The period of time from the end of the interest only period through the end of the term of the loan
    • The interest rate is typically re-calculated on an annual basis during the adjustable rate period
    • Interest only loans that convert into adjustable rate mortgages are called interest only ARMs
    Adjustment Interval
    • Indicates how often the interest rate for an interest only ARM adjusts during the adjustable rate period
    • The adjustment interval for most interest only ARMs is a year although some interest only ARMs have semi-annual (six month) intervals
    Fully-Indexed Rate
    • Interest rate for the adjustable rate period
    • Calculated by adding the index to the margin
    • The fully-indexed rate typically adjusts every year during the adjustable rate period and will change with fluctuations in interest rates
    Index
    • The index is an underlying interest rate that is one of two components of the fully-indexed rate
    • The value of the index can change over the term of the mortgage
    • Lenders typically use the 1 year LIBOR as the ARM index
    Margin
    • The second of two components used to calculate the fully-indexed rate
    • The margin is a set interest rate amount that does not change over the term of the loan
    • The margin is typically 2.0% - 2.5%
    Initial Adjustment Cap
    • A cap that limits the change in interest rate when it first adjusts following the interest only period
    • The initial adjustment cap is typically 2.0% or 5.0%
    • For example, if the initial adjustment cap is 5.0%, the initial fully indexed rate following the interest only period cannot go up by more than 5.0% as compared to the interest only period interest rate
    Subsequent Adjustment Cap
    • A cap that limits the change in the fully-indexed rate in any adjustment period following the initial adjustment
    Life Cap
    • A cap that limits the maximum increase in interest rate over the term of the mortgage
    • The typical life cap for an interest only ARM is 5.0% which means the fully indexed rate cannot exceed the initial interest only period interest rate plus 5.0%
  • Where You Can Find Information About an Interest Only Mortgage

    Lenders are required to provide a Loan Estimate that outlines key mortgage features, including interest only mortgage terms, within three business days of a borrower submitting a loan application.  The Loan Estimate for an interest only mortgage will indicate for how long you are paying only interest and no principal as well as if, when and by how much the interest rate and monthly payment can change (page 1).  The bottom of page 2 of the Loan Estimate has an Adjustable Payment (AP) table that indicates if you are making interest only payments and for how long as well as a range of estimated mortgage payments at the first adjustment period, how often the payment can change after the first adjustment and the maximum possible payment amount and when the maximum payment can occur.  The bottom of page 2 of the Loan Estimate also has an Adjustable Interest Rate (AIR) table that indicates the initial interest rate, the index and margin for when the interest rate is subject to change, the minimum and maximum interest rate, when the rate can initially adjust and how frequently it can adjust thereafter (adjustment interval); and, the limit on the change/increase in interest rate at the first adjustment period (initial cap) and subsequent adjustment periods (life cap).

  • Interest Only Mortgages Following the Real Estate Market Collapse
  • 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.

    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 (70.0% or below) to qualify for an interest only mortgage.  Not all lenders offer interest only mortgages 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. 

  • Interest Only Mortgage Rates
  • The interest 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 adjustable rate mortgage. Interest only mortgages are provided by traditional lenders such as banks, mortgage banks, mortgage brokers and credit unions.  Borrowers should shop multiple lenders to find the interest only mortgage with the lowest interest rate and fees. Click on lenders in the table below or INTEREST RATES to compare interest only mortgage rates.

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    Rate Details*
    Loan Program:  
    Monthly Payment:  
    APR:  
    Rate:  
    Points  More Info:
    Points: Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
     
    Total Lender Fees:  
    Loan type:  
    Property Value:  
    Loan to Value:  
    Credit Rating:  
    Date Submitted:  
    Monthly Housing Payments
    P & I More Info
    Principal & Interest: A periodic payment, usually paid monthly, that includes the interest charges for the period plus an amount applied to the reduction of the principal balance.
    Mortgage Insurance More Info
    Mortgage Insurance: The monthly cost for a policy that protects the lender in case you’re unable to repay the full amount of the loan. It is typically required for loans that have a loan-to-value ratio between 80% to 100%.
    (Estimated)
    Property Tax More Info
    Property Tax: (Also called "Real Estate Tax.") Property taxes are government assessments on real estate property. With mortgage financing, the local, county or state tax assessment on real estate property is considered part of the monthly housing obligation and typically collected and set aside by the lender ...
    (Estimated)
    Homeowner Insurance More Info
    Homeowner Insurance: or also commonly called hazard insurance, is the type of property insurance that covers private homes. It is an insurance policy that combines various personal insurance protections, which can include losses occurring to one’s home, its contents, loss of its use, or loss of other personal possessions of the homeowner, as well as liability insurance for accidents that may happen at the home or at the hands of the homeowner within the policy territory.lender ...
    (Estimated)
    Homeowner Association Fee More Info
    Homeowner Association fee: (HOA) fees are funds that are collected from homeowners in a condominium complex to obtain the income needed to pay (typically) for master insurance, exterior and interior (as appropriate) maintenance, landscaping, water, sewer, and garbage costs.
    (If Any)
    Total Monthly Housing Payments
    Lender Fees
    Points More Info
    Points Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
    Origination Fee More Info
    Origination Charge: A loan origination charge is a fee charged by the lender for evaluating, processing, and closing the loan.
    Credit Report Fee More Info
    Credit Report Fee: Fee charged to obtain an applicant’s credit history prepared by one or all of the three major credit bureaus. Used by lender to determine the borrower’s creditworthiness.
    Tax Service Fee More Info
    Tax Service Fee: A fee charged by the lender to cover the cost of retaining a tax service agency. These agencies monitor the property tax payments on the property and report the results to the lender.
    Processing Fee More Info
    Processing Fee: A processing fee is a charge by the lender for clerical items associated with the loan. Examples of processing include loan set up, organization of loan conditions for underwriting, and preparing required disclosures for the borrower.
    Underwriting Fee More Info
    Underwriting Fee: A fee charged by the lender to verify information on the loan application, authenticate the property’s value, and perform a risk analysis on the overall loan package.
    Wire Transfer Fee More Info
    Wire Transfer Fee: In most cases lenders wire funds to escrow companies to fund a loan. Commercial banks that perform this function will charge the lender so the fee is generally passed on to the borrower.
    (If Any)
    FHA Upfront Premium More Info
    FHA Upfront Premium: A fee paid in cash at the close of escrow or more commonly it is financed into the loan. These premiums are pooled together by the FHA and are used to insure the risk of borrower default on FHA loans. FHA upfront premiums are prorated over a five year period, meaning should the homeowner refinance or sell during the first five years of the loan, they are entitled to a partial refund of the FHA upfront premium paid at loan inception.
    (If any)
    VA funding Fee (If any)
    Flood Fee
    Other Fees More Info

    Other fees could be either additional Administrative Fees that a lender charges or it could be a Flat Fee to cover all lender charges such as: (Origination Fees, Points, Underwriting and Processing Fees, Credit Reports and Tax Service Fees)

    The flat fee does not include prepaid items and third party costs such as appraisal fees, recording fees, prepaid interest, property & transfer taxes, homeowners insurance, borrower’s attorney’s fees, private mortgage insurance premiums (if applicable), survey costs, title insurance and related services.

    Total Lender Fees
    *Actual rates and other information may vary. Sponsored results shown only include participating lenders. The information you enter on this page will only be shared with lenders you choose to contact, either by calling the phone number or requesting a quote.
    Compare Interest Only Mortgage Rates
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    Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. The actual payment obligation will be greater if taxes and insurance are included. Click here for more information on rates and product details.
  • How an Interest Only Mortgage Works
  • 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 adjustable rate mortgage (ARM) because you do not pay principal.  Because you do not pay principal during the initial interest only period, you still owe the entire mortgage amount at the beginning of the adjustable rate period when the loan converts into an amortizing mortgage.  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 mortgage term.

    The mortgage payment increases at the beginning of the adjustable rate period because the borrower is required to pay both interest and principal plus you have to repay the full loan amount over a shorter period of time which also causes the payment to increase. 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 only repay the loan balance over the final 23 years of the mortgage. 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 over the life of the loan.  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 mortgages with 30 year terms.  For the interest only mortgage, the interest rate for the interest only period (first seven years) is 3.000% and the interest rate is held at 4.000% -- the same as the fixed rate mortgage -- throughout the remaining 23 years of the loan (adjustable rate period).  Although having a constant interest rate throughout the adjustable rate period for an interest only mortgage is an unlikely scenario, it helps to illustrate the difference between the mechanics of the two mortgages.

    During the interest only period, the first seven years, the monthly payment for the interest only mortgage, $950, is lower than monthly payment for the fixed rate mortgage, $1,814.  In year eight, the monthly payment for the interest only mortgage increases significantly from $950 to $2,108  and is greater than the payment for the fixed rate mortgage for the remainder of the loan even though both loans have the same 4.000% interest rate.  The spike in payment is because in year eight the interest rate on for the interest only loan increases from 3.000% to 4.000%, the borrower is required to start paying both interest and principal plus the entire loan balance must be repaid over shorter period of time (23 years as compared to 30 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 interest only mortgage work.

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

    Interest Only Period

    Interest Rate: 3.000% Monthly Payment: $950

    Fixed Rate Mortgage

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

    Adjustable Rate Period

    Interest Rate: 4.000% Monthly Payment: $2,108

    Total Interest Expense

    Interest Only ARM: $281,608 Fixed Rate Mortgage: $273,040
    • 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
  • Why Select an Interest Only Mortgage
  • The main reason a borrowers 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 adjustable rate mortgage (ARM) because you are not paying any principal.  So if you know that you are only going to own the property during the interest only period 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 increase in interest rate and monthly mortgage payment during the adjustable rate period.  Additionally, you can typically qualify for a larger mortgage amount with an interest only mortgage because the monthly mortgage payment during the interest only period is lower.  With an interest only mortgage, however, you do not pay down your mortgage during the interest only period and therefore build no equity in your house unless the value of your property appreciates.

    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 mortgage payment during the interest only period.  Please note that for the 3/1, 5/1, 7/1 and 10/1 interest only mortgages and ARMs, the chart shows the monthly mortgage payment for the initial interest only and fixed rate periods, respectively.  Both the interest rate and mortgage payment are subject to change following the interest only and fixed rate periods.

  • Monthly Mortgage Payment for $380,000 Mortgage

    Monthly Mortgage Payment $2,125 $1,700 $1,275 $850 $425 $0
    • $831
      3/1 Interest Only ARM
    • $871
      5/1 Interest Only ARM
    • $950
      7/1 Interest Only ARM
    • $1,029
      10 / 1 Interest Only ARM
    • $1,501
      3/1 ARM
    • $1,526
      5/1 ARM
    • $1,551
      7/1 ARM
    • $1,628
      10 / 1 ARM
    • $1,760
      30 Year Fixed Rate
    Mortgage Program
  • Another reason to select an interest only mortgage is if you think that interest rates are going to decline significantly in the future.  If interest rates decline during the adjustable rate period of your interest only mortgage then your monthly mortgage payment may decline as well, although it will likely be higher than your monthly payment during the interest only period because your payment includes both principal and interest.  Predicting interest rates can be very challenging, especially over the 30 year term of a typical interest only mortgage, so this strategy exposes the borrower to significant risk.

    The final reason to select 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 for an interest only mortgage which reduces the 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 you can use your bonus to pay down principal.  Paying more than the required payment is called mortgage acceleration.  Mortgage acceleration reduces your mortgage term and can save you thousands of dollars in interest expense over the life of your mortgage.

  • Interest Only Period for an Interest Only Mortgage
  • The length of the interest only period directly affects the interest rate during the interest only period.  The shorter the interest only period, the lower the interest rate and the lower the monthly mortgage payment.  The trade-off of a shorter interest only period and lower interest rate is that the adjustable rate period is longer, which exposes the borrower to more risk that the interest rate will increase and remain higher for a longer period of time.

    The chart below demonstrates how the length of the interest only period impacts the interest only rate.  The 3/1 interest only mortgage has the lowest interest only period rate while the 10/1 interest only mortgage has the highest rate.  Additionally, the interest rate for an interest only mortgage during the initial interest only period is typically lower than the interest rate for a fixed rate mortgage.

  • Interest Rate Comparison

    Interest Rate 5.000% 4.000% 3.000% 2.000% 1.000% 0.000%
    • 2.625%
      3/1 Interest Only ARM
    • 2.750%
      5/1 Interest Only ARM
    • 3.000%
      7/1 Interest Only ARM
    • 3.250%
      10 / 1 Interest Only ARM
    • 3.750%
      30 Year Fixed Rate
    Mortgage Program
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