What is an Interest-Only Mortgage?

Interest-Only Mortgage Basics  

When most homeowners get a mortgage, they start paying both the interest and the principal immediately -- but they don’t always have to. One kind of home loan, called an interest-only mortgage, allows the buyer to put off paying any of the principal for a number of years while they save money and strengthen their financial position. But, just because you don’t have to pay principal doesn’t mean you can’t; many homebuyers just like to have an option that frees up more cash for their budget.

Who is an interest-only mortgage best for?

Interest-only mortgages are often best for first-time homebuyers, who want to purchase a home, but may not be able to afford high monthly mortgage payments. In addition, buyers with incomes that fluctuate (think realtors or other commission-based jobs) can benefit from interest only mortgages -- since they can choose to pay only interest during tougher months, and pay down the principal later.

Plus, if you’re really confident that your income will improve in a few years, an interest-only mortgage could help you buy a home now, while you (hopefully) wait to rake in the cash later. Plus, if you want to buy a second home as an investment, an interest-free mortgage can often allow you to do so without putting down major cash.

When and how do I pay the principal on a interest-only mortgage?

That depends. But first, consider that an interest-only mortgage isn’t a get-out-of-jail free card for buying a home (sorry, Monopoly lovers!). No matter what, you’ll still have to pay the principal at some point -- beginning at the end of your interest-only period.

While some people decide to stick with the interest-only mortgage for the long run, taking on payments with both interest and principal, others decide to sell their home (getting rid of the mortgage) or refinance their home for a (potentially) lower interest rate. Many people also save up cash during the interest-only period so that they can make a large, lump-sum payment on the home once the interest-only period is over.  

What is the risk of an interest-only mortgage?

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Unlike some ARMs, which may allow for negative amortization (i.e. an increasing loan balance as interest rates increase faster than your payments), the principal balance on a interest-only loan will never increase. So, that’s one thing you don’t have to worry about.

However, you could still get in trouble if the value of your home decreases during the life of your loan. If you haven’t paid any principal on your mortgage, you may wind up owing the bank and having no equity to speak of.

How much does it cost to get an interest-only mortgage?

Due to the fact that you won’t have to pay interest for a long time on your loan, your interest rate might be a little higher than average. For example, if a 30-year fixed mortgage is going for about 5%, a similar, interest-only mortgage might go for 5.5%.

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