When you hunt for a home loan, have you ever thought about an interest-only mortgage? This kind of mortgage doesn’t make you pay on principal at first; you only pay interest on the home loan and that reduces your monthly payment initially.
An interest-only mortgage is a big difference from a 30-year, fixed rate mortgage, which has you pay principal and interest. If you are thinking about an interest-only loan, below is more information and why demand for these interest-only mortgage program is rising. We published this article to explain what an interest only mortgage is and the pros and cons of this type of loan.
Why Interest-Only Mortgage Programs Are Getting More Popular
Interest-only mortgage loans offer advantages such as lower initial payments and cash flow flexibility, making them appealing to certain borrowers.
- Flexible Low Monthly Payments during the initial interest-only loan period.
- Interest Only Mortgages Can Increase Cash Flow
- Interest Only Loans still allows borrowers to make principal payments at their discretion.
However, they also come with risks, such as higher total interest costs and potential payment shocks. Before considering an interest only mortgage, carefully assess your financial situation, long-term goals, and risk tolerance to determine if it aligns with your homeownership strategy.
How Interest-Only Loans Work
Before we get into why interest-only loans are more popular, let’s talk about what an interest-only loan is.
A conventional loan, whether it’s 10, 15, or 30 years, requires you to make fixed payments on principal and interest for the loan’s life. At the start of the loan term, most of the payment is for interest. But as you get toward the end of the loan, you mostly pay on the principal. An interest-only loan lets you make a loan payment only on the interest during the first part of the loan. For instance, you may want to make an interest-only loan payment for the first five years of the loan.
This could be attractive if you are in school and have a lower income but expect a higher income later. If you will be making a lot of money after you are finished with school, this can work out well for you.
Also, an interest-only loan is what is called a nonconforming home loan. This means the loan isn’t backed by FHA, Fannie Mae, or Freddie Mac. These interest only loan mortgages aren’t as popular because they are backed by the US government and major financial organizations, so there aren’t as many of them available.
The home-equity line of credit is a popular second mortgage that is set up with a variable rate and an interest only payment option.
7 Reasons Why the Demand for Interest Only Mortgage Loans Surges
Even though these interest only mortgages aren’t as common as conforming loans, they are growing in popularity in 2024.
Why? Let’s take a look:
#1 Borrowers Love Low Monthly Payments
Lower payments are always popular, but why are they more popular at this time?
Well, the US economy isn’t doing as well as it could, with higher unemployment, fewer in the workforce, and inflation.
There are many of us who want to keep our out-of-pocket expenses down because of the economic uncertainty.
If you aren’t making principal payments on your home loan, you can put that money into savings. Or even better, you can invest the money and make a good return. This will give you more money put away if the economy and inflation get worse. Interest only loans offer increased cash flow for borrowers personally as they are more disposable income from a reduced mortgage payment.
#2 Preserve Cash and Increased Cash Flow
Related to the first point above, paying only interest on your loan allows you to keep more cash in the bank. You can invest your money, or even do home improvements that add to the property value. Lower initial payments free up cash that you can allocate to other investments, home improvements, or paying off higher-interest debt. This flexibility can be particularly appealing to real estate investors who want to maximize their cash flow.
#3 Interest Only Loans Can Be Easier to Qualify for
You only are making interest payments, so you can qualify with a lower income. If you are having trouble finding work in the pandemic economy, this could be a big benefit.
#4 Qualify For a Larger House
You may want to go for an interest-only mortgage if you’re confident that you will have more money in the future. For example, perhaps you are paying for medical school and know you will be making $200,000 per year in two years. Or, if you are going to inherit money, you can pay a lower payment now and eventually pay down the mortgage.
#5 House Prices Are Rising
The housing market is booming as inflation and demand for homes is rising. You may be able to buy a home with an interest-only mortgage and rely on the home appreciating in a few years so you can sell it at a big profit. However, this can be a risky strategy. You should be confident that you are buying the home in a market that is likely to appreciate for the foreseeable future.
#6 Lower Interest Rate
Interest-only mortgages are usually adjustable, so you will have a lower interest rate at first. This can be a big advantage if you don’t plan to stay in the home for longer than the temporary, fixed-rate period. But you should remember that the interest rate will eventually rise, so it’s important to sell the home before that happens.
#7 Uncertain Economic Environment
With the US economy experiencing inflation it hasn’t seen in decades, there is concern about where the country’s economy will be in the next several years. If you are concerned about finances and the economic uncertainty, it can make sense to conserve cash and put it into investments.
An interest only mortgage isn’t for every borrower. There are risks involved. But there’s no doubt that more buyers want to conserve their cash and only make interest payments on their home loans. So, talk to your mortgage lender today about interest-only loans and see if they are a good fit for your needs.
An interest-only mortgage is a type of home loan where the borrower is only required to make interest payments for a specific period, typically the first 5 to 10 years of the loan term. During this interest-only period, the borrower does not make any payments toward the loan’s principal balance. After the interest only payment period ends, the loan typically converts into a traditional mortgage, where both principal and interest payments are required for the remainder of the loan term.
Interest Only Mortgage Rates vs. Traditional Interest Rates
How do interest rates on interest-only loans stack up against other mortgage types? You might find that interest-only mortgages bear resemblance to adjustable-rate mortgages (ARMs) in terms of structure. Consequently, the interest rates for both types of mortgages tend to be similar.
Even if you secure a lower rate, the structure of interest-only mortgages generally means you’ll end up paying more in interest over the life of the loan. Regardless of your preference, it’s important to review current mortgage rates to make a well-informed decision.
The Pros and Cons of the Interest-Only Mortgage
When it comes to mortgages, there are various types to choose from, each with its unique features and benefits.
One option that might pique your interest is the interest-only mortgage.
This type of loan allows you to pay only the interest for a specified period, typically the first five to ten years, without reducing the principal balance.
After this initial period, your payments may increase significantly as you start paying down the principal.
Like any financial product, interest-only mortgages come with their set of pros and cons.
The Pros of Interest-Only Mortgages:
- Lower Initial Payments: One of the primary advantages of interest-only mortgages is that they offer lower initial monthly payments compared to traditional fixed-rate mortgages. This can make homeownership more accessible for some borrowers, especially during the early years of the loan.
- Flexibility: Interest-only mortgages can provide flexibility in managing cash flow, as borrowers have the option to make additional payments toward the principal if they choose. This flexibility can be valuable for those with irregular income or who anticipate an increase in income in the future.
- Higher Future Payments: While the initial payments are lower, it’s important to understand that once the period of interest only period mortgage, the monthly payments typically increase significantly. This can catch some borrowers off guard, and it’s crucial to budget for these future increases.
- No Equity Buildup: During the interest only payments period, the borrower is not building equity in the home because they are not reducing the principal balance. This means that if home values decrease, the borrower could find themselves owing more than the home is worth.
- Risk of Payment Shock: The transition from interest-only payments to full principal and interest payments can result in a significant payment shock for some borrowers. It’s essential to be prepared for this increase and have a plan in place to manage it.
- Qualification Criteria: Lenders typically have stricter qualification criteria for interest-only mortgages, including higher credit score requirements and lower debt-to-income ratios. This is because these loans carry more risk due to the potential for future payment increases.
- Shorter Loan Terms: Interest-only mortgages are often offered with shorter loan terms, such as 30-year terms with a 10-year interest-only loan. This means that borrowers need to be prepared to pay off the loan or refinance it when the interest-only period ends.
- Tax Deductibility: In some cases, the interest portion of your mortgage payment might be tax-deductible, potentially reducing your overall tax liability.
- Investment Opportunities: With an interest-only mortgage, you can invest the savings elsewhere, aiming for a higher return. If your investment gains outperform the mortgage interest rate, you could come out ahead.
The Cons of Interest-Only Mortgages:
Higher Total Interest Costs: By not paying down the principal balance during the interest-only period, you’ll end up paying more in interest over the life of the loan compared to traditional mortgages.
Balloon Payments: At the end of the interest-only period, your monthly payments typically increase significantly. This can be a shock to your finances if you’re unprepared. Some loans have a balloon payment at the end, meaning the entire unpaid balance is due at once.
Limited Equity Buildup: Since you’re not reducing the principal balance, you’re not building equity in your home during the interest-only phase. This means you might not see much appreciation in your home’s value during this time.
Risk of Falling Home Values: If the housing market experiences a downturn during the interest-only period, you may owe more on your mortgage than your home’s current value. This situation is often referred to as negative equity.
Qualification Challenges: Interest-only loans are often more challenging to qualify for than standard mortgages. Lenders may require higher credit scores and stricter income verification.
Short-Term Thinking: Some borrowers choose interest-only mortgages because they can afford the lower payments, but they have no clear strategy for paying off the principal later. Without a plan in place, they may end up with a hefty lump sum due at the end of the interest-only period.
Interest Rate Risk: If you have an adjustable-rate interest-only mortgage, you’re exposed to interest rate fluctuations. If rates rise significantly during the interest-only period, your future payments could become unaffordable.
It’s essential for people considering an interest-only mortgage to carefully consider the pros and cons and ensure they understand the mortgage terms, including when the interest-only period ends and how the loan will adjust at that point. Additionally, borrowers should have a clear plan for handling the higher payments that will come into effect when the interest-only period concludes.
Interest-only mortgages can be beneficial for specific borrowers, such as those with irregular income or who plan to sell the property before the interest-only period ends. However, they also come with risks, particularly if borrowers are not prepared for the eventual increase in monthly payments. We suggest that you always consult with an experienced lending professional is advisable to determine whether an interest-only mortgage aligns with your financial goals now and in the future.
Who Benefits from Interest-Only Mortgages?
Interest-only mortgages can be a valuable tool for certain individuals in specific financial situations. Here are a few scenarios where they might be beneficial:
Real Estate Investors: Real estate investors often use interest-only mortgages to maximize their cash flow from rental properties, allowing them to allocate funds to other investments.
Short-Term Ownership: If you plan to own a home for a short period, an interest-only mortgage can provide lower initial payments while you’re in the property, and you can sell before the interest-only period ends.
High Earners with Irregular Income: Individuals with irregular income patterns, such as commission-based or self-employed professionals, may benefit from the lower initial payments an interest-only mortgage provides.
Financially Disciplined Borrowers: Those who use interest-only mortgages but are committed to creating a plan to pay down the principal can benefit from the lower initial payments.
Consulting with a financial advisor or mortgage professional can provide valuable insights to make an informed decision regarding this mortgage type.
Takeaway on Interest Only Loan Mortgages
Contrast the interest only loan mortgages with a conventional mortgage, where your monthly payments include both principal and interest right from the start. For example, if you opt for a standard 30-year fixed-rate mortgage, your monthly payments will stay consistent throughout the entire term of the mortgage.
Using an interest-only mortgage means you defer principal payments for several years, which results in lower payments initially. However, this also means that your monthly payments will increase later when you begin paying down the principal. This significant tradeoff is something to carefully consider.
We recommend you speak with your financial advisor and several trusted mortgage lenders before committing to a an interest only mortgage. The RefiGuide can help you locate experienced mortgage companies that specialize in an interest only mortgage for refinancing or home buying.
What Do You Call an Interest-Only Loan?
An interest-only loan is a type of loan where the borrower initially pays only the interest on the principal for a set period, without reducing the loan balance. This period typically ranges from 5 to 10 years. After the interest-only period, the loan converts to a standard repayment schedule, requiring both principal and interest payments. Interest only home loans are often used in real estate and business lending, offering lower initial payments, which can be attractive for buyers expecting higher future income or investment returns. However, since the principal remains unpaid during the interest-only phase, borrowers may face higher payments once the repayment period begins.
How to Calculate Payment on an Interest-Only Loan?
To calculate the payment on an interest only mortgage, multiply the loan’s principal by the annual interest rate, then divide by 12 to determine the monthly payment.
For example, if the loan amount is $100,000 with an annual interest rate of 5%, the monthly interest payment would be (100,000×0.05)÷12=416.67(100,000 \times 0.05) \div 12 = 416.67. This formula applies only during the interest-only period, after which principal repayments begin, increasing the monthly payment.
We suggest using an online calculators and spreadsheets can simplify these interest only calculations, helping borrowers understand future payment obligations and plan accordingly.
Is Interest Only Mortgage Cheaper?
The interest only monthly payment is lower than a traditional loan or conventional mortgage payment that is a principal and interest payment. The interest rates on an interest only mortgage are typically now lower. In most cases the interest only mortgage has an interest rate that is slightly higher than your average P and I payment. The closing costs on interest only mortgage programs are typically very similar as a conventional loan.
Do HELOCs Have Interest-Only Monthly Payments?
Yes, the Home Equity Lines of Credit or HELOC typically offer interest-only payments during the draw period, which usually lasts 5 to 10 years. During this phase, borrowers are only required to pay the accrued interest on the amount drawn from the credit line, making monthly payments lower. Once the draw period ends, the HELOC transitions into the repayment period, where both principal and interest must be paid. Learn more about how HELOC interest is calculated. This shift can result in significantly higher monthly payments. Borrowers should plan ahead to manage these increased payments and avoid potential financial strain when the repayment phase begins.
About Dusty
Dusty Brazil is a licensed California real estate agent CA BRE #01780273 and proud to call himself a Realtor with Pacific Sotheby’s International Realty in Del Mar, CA. He's a native to Southern California and local in North County San Diego for over 25 years. You can learn more about him at Twitter, Linkedin, RealtyTimes, and Youtube.
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