How Do Interest-Only Mortgages Work? (2024)

If you want a monthly payment on your mortgage that’s lower than what you can get on a fixed-rate loan, you might be enticed by an interest-only mortgage. By not making principal payments for several years at the beginning of your loan term, you’ll have better monthly cash flow.

But what happens when the interest-only period is up? Who offers these loans? And when does it make sense to get one? Here is a short guide to this type of mortgage.

How Interest-Only Mortgages Are Structured

At its most basic, an interest-only mortgage is one where you only make interest payments for the first several years—typically fiveor 10—and once that period ends, you begin to pay both principal and interest. If you want to make principal payments during the interest-only period, you can, but that’s not a requirement of the loan.

You’ll usually see interest-only loans structured as 3/1, 5/1, 7/1, or 10/1 adjustable-rate mortgages (ARMs). Generally, the interest-only period is equal to the fixed-rate period for adjustable-rate loans.That means if you have a 10/1 ARM, for instance, you would pay interest only for the first 10years.

On aninterest-only ARM, after the introductory period ends, the interest rate will adjust once a year (that’s where the “1” comes from) based on a benchmark interest rate such as the Fed Funds Rate or the secured overnight financing rate (SOFR) plus a margin determined by the lender. The benchmark rate changes as the market changes, but the margin is predetermined at the time you take out the loan.

Rate caps limit Interest-rate changes. This is true of all ARMs, not just interest-only ARMs. The initial interest rate cap on 3/1 ARMs and 5/1 ARMS is usually two, says Casey Fleming, author of "The Loan Guide: How to Get the Best Possible Mortgage." That means if your starting interest rate is 3%, then asthe interest-only period ends in year four or year six, your new interest rate won’t be higher than 5%. On 7/1 ARMs and 10/1 ARMs, the initial rate cap is usually 5%.

After that, rate increases are usually limited to 2%per year, regardless of what the ARM’s introductory period was. Lifetime caps are almost always 5%above the loan’s starting interest rate, Fleming says.So if your starting rate is 3%, it might increase to 5%in year eight, 7%in year nine, and max out at 8% in year 10.

Once the interest-only period ends, you’ll have to start repaying principal over the rest of the loan term—on a fully-amortized basis, in lender speak. Today’s interest-only loans do not have balloon payments; they typically aren’t even allowed under law, Fleming says. So if the full term of a 7/1 ARM is 30 years and the interest-only period is seven years, in year eight, your monthly payment will be recalculated based on two things: first, the new interest rate, and second, the repayment of principal over the remaining 23 years.

Fixed-Rate Interest-Only Loans

Fixed-rate interest-only mortgages are not as common. With a 30-year fixed-rate interest-only loan, you might pay interest only for 10years, then pay interest plus principal for the remaining 20 years. Assuming you put nothing toward the principal during those first 10years, your monthly payment would jump substantially in year 11, not only because you’d begin repaying principal, but because you’d be repaying principal over just 20 years instead of 30 years. Since you aren’t paying down principal during the interest-only period, when the rate resets, your new interest payment is based on the entire loan amount.

A $100,000 loan with a 3.5%interest rate would cost just $291.67 per month during the first 10years,but $579.96 per month during the remaining 20 years(almost double).

Over 30 years, the $100,000 loan would cost you $174,190.80—calculated as ($291.67 x 120 payments) + ($579.96 x 240 payments). If you’d taken out a 30-year fixed rate loan at the same 3.5%interest rate (as mentionedabove), your total cost over 30 years would be $161,656.09. That’s $12,534.71 more in interest on the interest-only loan, and that additional interest cost is why you don’t want to keep an interest-only loan for its full term. Your actual interest expense will be less, however, if you take the mortgage interest tax deduction.

Are These Types of Loans Widely Available?

Since so many borrowers got in trouble with interest-only loans during the housing bubble years, banks are hesitant to offer the product today, says Yael Ishakis, vice president of FM Home Loansin Brooklyn, N.Y., and author of "The Complete Guide to Purchasing a Home."

Fleming says most are jumbo, variable-rate loans with a fixed period of five, seven,or 10years.A jumbo loan is a type of nonconforming loan. Unlike conforming loans, nonconforming loans aren’t usually eligible to be sold togovernment-sponsored enterprises,Fannie Mae and Freddie Mac—the largest purchasers of conforming mortgages and a reason why conforming loans are so widely available.

When Fannie and Freddie buy loans from mortgage lenders, they make more money available for lenders to issue additional loans. Nonconforming loans like interest-only loans have a limited secondary mortgage market, soit’s harder to find an investor who wants to buy them.More lenders hang on to these loans and service them in-house, which means they have less money to make additional loans. Interest-only loans are therefore not as widely available. Even if an interest-only loan is not a jumbo loan, it is still considered nonconforming.

Because interest-only loans aren’t as widely available as, say, 30-year fixed-rate loans, “the best way to find a good interest-only lender is through a reputable broker with a good network, because it will take some serious shopping to find and compare offers,” Fleming says.

Comparing the Costs

“The rate increase for the interest-only feature varies by lender and by day, but figure that you will pay at least a 0.25%premium in the interest rate,” Fleming says.

Similarly, Whitney Fite, specialty lending, SVP at Capital City Home Loans, says the rate on an interest-only mortgage is roughly0.125%to 0.375%higher than the rate for an amortizing fixed-rate loan or ARM, depending on the particulars.

Here’s how your monthly payments would look with a $100,000 interest-only loan compared with a fixed-rate loan or a fully amortizing ARM, each at a typical rate for that type of loan:

• 7-year, interest-only ARM, 3.125%: $260.42 monthly payment
• 30-year fixed-rate conventional loan (not interest-only), 3.625%: $456.05monthly payment
• 7-year, fully amortizing ARM (30-year amortization), 2.875%: $414.89monthly payment

At these rates, in the short term, an interest-only ARM will cost you $195.63 less per month per $100,000 borrowed for the first seven years compared with a 30-year fixed-rate loan, and $154.47 less per month compared with a fully amortizing 7/1 ARM.

It’s impossible to calculate the actual lifetime cost of an adjustable-rate interest-only loan when you take it out because you can’t know in advance what the interest rate will reset to each year. There isn’t a way to ballpark the cost, either, Fleming says, though you can determine the lifetime interest rate cap and the floor from your contract.This would allowyou to calculate the minimum and maximum lifetime cost and know that your actual cost would fall somewhere in between. “It would be a huge rangethough,” Fleming says.

Tax Implications of Interest-Only Mortgages

There are several tax implications to consider with interest-only mortgages. First, the interest on a mortgage loan may be tax deductible in several nations including the United States. As a result, borrowers may be able to reduce their overall tax obligation by deducting the interest component of their interest-only mortgage payments from their taxable income.

Second, the interest payments on an interest-only mortgage for an investment property may be deducted as a business cost. This can also lower the taxable income from the rental property and assist offset rental income. Be mindful that these types of loans may be more difficult to secure for a new business.

Last, borrowers may have greater cash flow available for other objectives such as investing or establishing a business, by making smaller initial monthly payments during the interest-only term. Due to the additional liquidity, there may be prospects for tax benefits related to those operations. For example, investors may use cash savings to invest in equities until principal payments are required; this may result in higher-than-usual capital gains or losses.

The Bottom Line

Interest-only mortgages can be challenging to understand, and your payments will increase substantially once the interest-only period ends. If your interest-only loan is an ARM, your payments will increase even more if interest rates increase, which is a safe bet in a low-rate environment. These loans are best for sophisticated borrowers who fully understand how they work and what risks they’re taking.