What is an Interest Only Mortgage?

As the name suggests, an interest only mortgage is one where borrowers pay interest alone for a specific amount of time. During this period, the principal balance remains unchanged, allowing for reduced monthly mortgage payments early in the loan term. 

Interest only home loans can offer the ability to lower payments so borrowers can divert their cash flow toward retirement, college tuition, or other savings goals. 

Interest only mortgages can be either conforming or jumbo loans, depending on the size of the mortgage in relation to pre-established limits on home loans. Despite their variation, the majority of these home loans will have an interest only period that lasts from five to ten years. Following that period, the borrower would begin to make payments towards the principal balance in addition to the interest, increasing monthly payment amounts.  

How do Interest Only Mortgages Work?

Traditional mortgages apply monthly payments towards both the interest and principal balance. Interest only mortgages differ in their payment structure: borrowers will only pay interest for the first five to ten years.

Interest only payments make initial payments lower than traditional ones; however, borrowers should note that they are more costly in their entirety than traditional loans. In addition, interest only loans may be subject to adjustable interest rates. Negative amortization, a feature where missed interest payments are applied to the principal balance, is also a risk associated with interest only loans.  

When Does This Financing Strategy Make Sense?

There are several scenarios where pursuing an interest only loan may be the best financial strategy:

First-Time Homeowners

First-time home buyers may find interest only mortgages beneficial. New homeowners may be unaccustomed to the higher costs of maintaining a home, making the first few years of homeownership more challenging. 

Freelance and Commission Workers

If your income is subject to fluctuation either because of freelance work, commissions, or bonuses, an interest-only mortgage can be beneficial. A sound financial strategy could entail making interest-only payments during leaner months or years with the anticipation of paying more later on.

You’re Ready to Buy High-Value Real Estate Now

For those that are anticipating a larger income in the future, but are looking to purchase a higher-priced home in the present, an interest-only payment structure helps to make payments more affordable during the beginning years of the loan. 

Those Looking to Divert Their Income to Other Sources

Interest-only, jumbo, adjustable rate mortgage (ARM) loans are popular with borrowers looking to prioritize lower initial monthly payments over building equity in the home. An interest only mortgage product could allow you to divert your income to other sources, such as investments, or saving for a college tuition or retirement. 

Is an Interest Only Mortgage Right for You?

Consider the following when determining if an interest only mortgage is a good fit for your financial strategy: 

  • Are you confident that your income will increase in the future, but looking to purchase a high-value property now?

  • Are you looking to invest your money in something other than your home?

  • Are you more interested in lower monthly mortgage payments than building home equity?

  • Do you own investment homes and rent them out?

If one or more of these questions apply to you, an interest only mortgage may be a financial strategy to consider. However, keep in mind that while interest only loans offer low monthly payments during the initial term of your mortgage, your monthly payments will increase after this period ends to cover the principal balance. 

The initial costs associated with buying a home can seem daunting. If your water heater or the roof suddenly need replacing, the option to exercise an interest only mortgage can come in handy. If you’re anticipating a shift in income as you become more established in the future, covering higher monthly payments later on can give you the flexibility you need in the present.