What is an Interest-Only Mortgage?

Interest-only (I/O) mortgages are adjustable-rate or fixed-rate loans, which contain an interest-only payment option during a set period in the first years of the loan, often the first 10 years. During the interest-only period, borrowers can delay making principal payments and make monthly payments that only repay interest. After the interest-only period ends, assuming that a borrower selected this option and made only interest payments, the monthly payments would significantly increase when the required monthly payments started to include principal plus interest. If there were no principal payments made during the interest-only payment period, the unpaid loan principal wouldn’t be reduced. That principal would now need to be paid back in the remaining years of the loan, in addition to the interest due on the total balance of the loan. So the payment shock would be quite significant when the interest-only period ends. In general, interest-only mortgages may be a good choice for only a small number of buyers with very special circumstances. Carefully consider payment shock when considering an interest-only payment option.

Advantages

This type of mortgage may be a fit for a small sub-set of buyers with fluctuating incomes, as long as they are disciplined enough to pay more than the minimum as often as they can and/or plan to pay larger amounts in the future.

Considerations

Because your monthly payment would only repay the interest accruing on this mortgage, the only equity you would have in your home would be the amount you paid as a down payment. You would not build equity unless the market value of your home were to increase. If the market value of your home were to decline, then you could lose part or all of your down payment. This kind of mortgage can be difficult to get because it is more of a risk for lenders. It’s critical to know the highest possible monthly payment you may have to make on this loan, and to be confident you could pay it.

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Evaluating an Interest Only Mortgage

  • If you’re opting for lower starting payments to invest money into home renovations or remodeling, because you believe that these would significantly increase the home’s value and you could refinance or sell in the future.
  • f you know you’ll be moving before the interest-only payment term expires, and you don’t need to access the equity (your down payment contribution) from the home in order to buy a new one.
  • If the bulk of your income is paid in bonuses or commissions, and you want to make small monthly payments and use large income distributions to periodically pay down principal.
  • If you expect significant income increases in the short term, like a spouse going back to work.