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