Interest-Only Mortgage Pros and Cons: Is It Right for You?
If you are getting ready to embark on the homebuying process and are planning to take out a mortgage, then it’s helpful to familiarize yourself with the different mortgage loan options that are available to you. By doing this, you can establish which loan is best for you depending on your unique situation.
We’re here to provide an inside look into an interest-only mortgage and dive into the important information to know about this type of loan.
What Is an Interest-Only Mortgage?
An interest-only mortgage is a home loan that allows an individual to only pay the interest fee on the first few years of the loan. This time frame can last up to 10 years, but generally lasts between 3 to 10 years. With an interest-only loan, the monthly payments will be lower during the introductory period than with a conventional loan. Following that period, the borrower is required to make larger payments towards both the interest and the principal.
At that point, the borrower is faced with a few different options:
- Refinance their mortgage
- Pay the remaining balance in a lump sum
- Start making regular monthly payments
The borrower will also have the option of making principal payments during their interest-only payment term. A principal payment is a payment that goes toward the original amount of a loan that is owed, and will help reduce the overall amount that they owe.
What Are Adjustable Rate Mortgages?
There are a few different ways that interest-only loans are structured but most are structured as an adjustable-rate mortgage. Also referred to as an ARM, an adjustable-rate mortgage does not have a fixed interest rate. Instead, an ARM means that the interest rate can adjust over time and can fluctuate depending on the market conditions. Adjustable-rate mortgages also typically offer a lower initial interest rate than fixed-rate loans.
Pros of Interest-Only Mortgages
Interest-only mortgages can be a good option for the right buyer, but be sure to carefully consider the pros and cons of this type of mortgage loan. Let’s start with the pros.
Lower Monthly Payments
One perk of obtaining an interest-only mortgage is lower initial payments. This can stretch out for as many as 10 years, but more commonly for less time. You can use an interest-only mortgage calculator to get an idea of what your monthly mortgage payment would be. Doing this will provide you with a breakdown on an approximate amount for your payments with interest-only, and the following years when principal rates kick in after the introductory period. By comparing this to your financial situation and estimated budget, you’ll be able to see if an interest-only mortgage works for you.
Frees Up Cash Flow
Lower monthly payments means you can use those extra dollars elsewhere, which can be an appealing aspect to some potential buyers. Some homeowners decide to put this extra money toward investments to build net worth.
Cons of Interest-Only Mortgages
While interest-only mortgages are cheaper initially, which can be tempting, there are some downsides to be aware of. Read on for some cons to keep in mind before you go for this option.
This type of loan generally comes with higher interest rates compared to a conventional mortgage loan. Once the interest-only period ends, the borrower will be responsible for paying both the interest and the principal. This means that the monthly mortgage payment could increase by quite a lot and cause “payment shock.” In the unfortunate event of a payment becoming unaffordable, borrowers can contact the lender to try to negotiate a longer term or the possibility of refinancing the loan for a cheaper mortgage rate.
Because most interest-only mortgages are structured as adjustable-rate mortgages, there’s a chance that the interest rates will rise higher than expected when the time comes to start paying it. Additionally, since the borrower will be making more payments on interest overall, they will end up paying more in interest over time than they would with a conventional mortgage.
Not Building Equity on Your Home
Building home equity is beneficial to homeownership because it decreases your debt and provides financial security. One downside to consider with this type of loan is that you are not building equity on your home for years while you pay interest-only on the mortgage. You will only start building equity once you start making payments toward the principal.
How Do I Qualify for an Interest-Only Mortgage?
Because interest-only mortgages aren’t qualified loans, you’ll find that there are more restrictions to qualify. Since the housing crisis in 2008, it has become more difficult to qualify for an interest-only mortgage. This is because lenders take on a bigger risk when they give out interest-only mortgages, which means that they are often selective about giving out this type of mortgage.
Here is what the bank is typically looking for when giving out the mortgage:
- A down payment of at least 15-30% (depending on the lender)
- Minimum credit score of 700 or higher
- Sufficient income and assets to repay the loan
How Do I Know If an Interest-Only Mortgage Is Right for Me?
Interest-only mortgages aren’t for everyone — so how do you know if this is the right choice for you? Here’s some ways that you can tell if this type of loan is best for you.
- You want more cash flow elsewhere. For those who can afford the monthly payment but are wanting to put the extra cash flow somewhere else, an interest-only mortgage might be the best course of action. After all, lower monthly payments enable you to use that money elsewhere, such as an investment opportunity or principal payments.
- You want to buy a rental. If you’re looking to use a home as a long or short-term rental, having an interest-only mortgage can lower your monthly expenses.
Start Your Homebuying Journey With Aalto Today
By understanding your loan options, you can decide which mortgage loan is best for your unique situation — whether it be a home equity loan, interest-only loan, or conventional loan. Aalto is there to assist homeowners through every step of the process, from your initial search to signing the final paperwork.
Buying a home can feel overwhelming but with Aalto by your side, it doesn’t have to be. We are committed to transforming the homebuying and selling process, and making it easier than ever before. As a buyer, you can browse Aalto’s self-service real estate platform to see houses available in your area. Deciding to buy with Aalto means that you can look forward to saving on commission costs — and even receive up to 1.5% cash back when you buy a home.
We work with buyers on their terms and on their timeline. You won’t need to hire a real estate agent. Instead, our licensed professionals are available to answer questions and provide sound advice so you can be in full control. Get started on Aalto today to start your journey to homeownership.
Aalto is a real estate broker licensed by the State of California, License #02062727 and abides by Equal Housing Opportunity laws. This article has been prepared solely for information purposes only. The information herein is based on information generally available to the public and/or from sources believed to be reliable. No representation or warranty can be given with respect to the accuracy of the information. Aalto disclaims any and all liability relating to this article.