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Interest Only Mortgage Pros and Cons
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Interest Only Mortgage Pros and Cons

Michael Jensen, Mortgage and Finance Guru
, Mortgage and Finance Guru
With an interest only mortgage you pay only interest at a fixed rate for the initial period of the loan -- usually the first three, five, seven or ten years -- which is called the interest only period, and then you pay both principal and interest and your mortgage rate and monthly payment are subject to change semi-annually or annually for the remainder of the loan, which is called the adjustable rate period.

An interest only mortgage offers both positives and negatives when compared to a fixed rate mortgage or adjustable rate mortgage (ARM).  Interest only mortgage benefits include a lower initial monthly payment, the ability to afford a larger loan and the flexibility to pay down your principal mortgage balance how and when you want to.  Negatives include a potential significant increase in monthly payment as wells as greater risk and uncertainty as compared to a fixed rate mortgage or ARM. 

We review the full list of the pros and cons for an interest only mortgage below.  Borrowers should understand both the positives and negatives of an interest only mortgage to determine if it is the right mortgage program for them.

Interest Only Mortgage Pros

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Lower Initial Monthly Payment

With an interest only mortgage you pay only interest and no principal at a fixed interest rate during the initial three, five, seven or ten years of the loan, which is called the interest only period.  Following the interest only period the mortgage changes into an amortizing loan and you are required to pay both interest and principal and your interest rate is subject to change and potentially increase semi-annually or annually for the remainder of the 30 year loan term.  These mortgages are called 3/1, 5/1, 7/1 and 10/1 interest only ARMs or IO ARMs for short.  Because you are not required to pay principal during the initial interest only period of the loan, your monthly mortgage payment is lower than the payment for fixed rate mortgage or an adjustable rate mortgage (ARM).  The lower monthly payment for an interest only mortgage reduces your total monthly housing expense and provides additional financial flexibility as compared to other mortgage programs.


The table below shows interest only mortgage rates and costs for leading lenders in your area.  The table compares five and seven year interest only ARMs, with the shorter the interest only period, the lower the initial rate rate and monthly payment. Contact multiple lenders to compare loan options and find the best interest only mortgage terms.

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Current Adjustable Rate Mortgage (ARM) Rates as of January 23, 2019
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Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. Click here for more information on rates and product details.
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Afford Larger Mortgage

The lower initial monthly payment for an interest only mortgage potentially enables borrowers to qualify for a larger loan amount as compared to a fixed rate mortgage or ARM.  A lower monthly payment allows borrowers to afford more mortgage while a higher payment reduces what size loan you can afford.  For example, borrowers can typically qualify for a 10% - 20% larger mortgage with an interest only loan as compared to other mortgage programs.  The ability to qualify for a higher loan amount is particularly helpful for borrowers looking to stretch their mortgage dollars to buy more home.

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Flexibility to Pay Down Principal When You Want To

Just because an interest only mortgage does not require borrowers to pay down their principal balance during the initial period of the loan does not mean borrowers cannot pay down their mortgage on their own.  Interest only loans offer borrowers flexibility over when and how much you pay down your mortgage balance.  Borrowers can pay down their balance by any amount at any time over the course of the loan.  For example, if a significant portion of your income comes from an annual or semi-annual bonus then an interest only mortgage may work well because you make lower monthly payments over the course of the year and you can use your bonus to pay down your loan balance.  As an added benefit, if you pay down your mortgage balance during the interest only period of the loan it reduces your required monthly payment, which enhances your financial flexibility. Paying more than your required payment is called mortgage acceleration.  We provide a comprehensive overview of how mortgage acceleration can be applied to an interest mortgage.

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Good for Borrowers Who Will Own Home for a Fixed Time Period

If you know you are only going to own your home for a fixed period of time, such as three-to-ten years, then an interest only mortgage may work for you.  In this case you benefit from the lower monthly payment during the interest only period of  the loan when you pay only interest and your mortgage rate does not change, but you are not exposed to the risk that your mortgage payment and interest rate could increase significantly for the remainder of the loan.  For example, borrowers who know they are going to own their homes for less than seven years can obtain a 7/1 interest only ARM which offers a lower interest only payment and fixed interest rate for the first seven years of the loan before converting into an amortizing, adjustable rate mortgage for the remaining 23 years of the loan.


Due to regulatory restrictions and other considerations, a relatively small number of lenders offer interest only loans.  Use the FREEandCLEAR Lender Directory to find leading lenders in your state that offer interest only mortgages.

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Interest Only Mortgage Cons

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Potential Spike in Monthly Mortgage Payment

With an interest only mortgage your monthly payment increases when the loan converts into an amortizing mortgage and your monthly payment is comprised of both principal and interest instead of only interest.  Additionally, if you have not paid down any of your mortgage balance during the interest only period, your mortgage payment increases even more because you are amortizing your entire loan amount over a shorter period of time as compared to a 30 year fixed rate mortgage or ARM.  Finally, your interest rate is subject to change and potentially increase significantly during the adjustable rate period of the loan.   A significant increase in your interest rate can result in a spike in your monthly payment.  Although your interest rate and monthly payment only change semi-annually or annually with an interest only loan, borrowers may be caught off guard by a sudden increase in their payment, especially if your interest rate increases when you are required to start paying principal, which causes your payment to increase even more.  In the most severe case, your monthly payment could more than double and you may not be able to afford the new, higher payment.  While this scenario is unlikely, borrowers should be aware of potential payment shock over the course of their loan before selecting an interest only loan.  Borrowers should review our explanation of the downside of an interest only mortgage, when the mortgage rates increases as much as possible as quickly as possible, to understand the potential risks.  

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Takes Longer to Build Equity in Your Home

With an interest only loan, you do not pay down your mortgage balance during the initial three-to-ten years of the loan which means you build less equity in your home as compared to a fixed rate mortgage or ARM when you pay down your mortgage balance and build equity over your entire loan term.  For example, with a 7/1 interest only mortgage, if you make the required mortgage payments for the first seven years of the loan, you do not pay down any principal and your mortgage balance at the end of year seven is the same as your initial loan amount.  By comparison, after seven years with a fixed rate mortgage you have paid off approximately 15% of your mortgage which means you have built more equity in your home.  With both an interest only mortgage and a fixed rate mortgage, your entire principal balance is paid in full at the end of your loan term, but with and interest only loan you pay down mortgage and build equity in your home more slowly.    

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Greater Risk and Uncertainty

An interest only mortgage is generally considered a higher risk home finance option as compared to a fixed rate mortgage or ARM.   With a fixed rate mortgage, your interest rate and monthly payment are fixed and cannot change over the life of the mortgage, even if interest rates increase significantly.  With an ARM your interest rate and monthly payment can increase; however, you pay down principal over your entire loan term, which helps mitigate some of your risk.  An interest only mortgage subjects borrowers to the highest possible increase in monthly mortgage payment over the course of the loan, which can put borrowers in a serious financial bind.  Borrowers should carefully weigh the financial benefits against the risks before selecting an interest only mortgage.

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More Challenging Mortgage Qualification Requirements

When the real estate market collapsed many borrowers with interest only mortgages defaulted on their loans because they could not make their mortgage payment when it increased.  As a result, the government imposed stricter regulations on interest only mortgages which caused most lenders to stop offering them.  With the improvement in the economy and real estate market, more lenders are offering interest only mortgages again although many lenders impose more challenging borrower qualification requirements as compared to other types of mortgages.  Lenders may require higher borrower credit scores and in some cases apply a lower loan-to-value (LTV) ratio limit (maximum of 70%) to qualify for an interest only loan.  Borrowers should understand a lender's specific borrower qualification requirements for an interest only mortgage.

More FREEandCLEAR Resources

Mortgage Guides

How an Interest Only Mortgage Works

Review our comprehensive overview of how an interest only mortgage works including key program terminology, reasons to select and interest only mortgage as well as informative examples and illustrative charts.

Mortgage Calculators

Interest Only Mortgage Calculator

Use our Interest Only Mortgage Calculator to determine your initial monthly payment, future payments and worst case scenario for an interest only mortgage based on numerous factors including interest rate, interest only period length, index, margin and adjustment caps.

Resources

Interest Only Mortgage Rates

Review interest only mortgage rates in your area based on interest only period rate and length, discount points, credit score and other inputs.  Comparing interest only mortgage from multiple lenders is the best way to find the mortgage with the lowest rate and fees.  Due to regulatory considerations and other issues, not all lenders offer interest only mortgages so use the Interest Only Mortgage Rate Table on FREEandCLEAR to find lenders that do.

Resources

Mortgage Program Comparison

Compare interest only, fixed rate and adjustable rate (ARM) mortgages including key features such as monthly payment, interest rate and borrower risk tolerance to determine the program that meets your personal and financial objectives.

Sources

Interest Only Mortgage: https://www.consumerfinance.gov/ask-cfpb/what-is-an-interest-only-loan-en-101/

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

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