An interest-only loan is anadjustable-rate mortgagethatallows the borrower to pay just the interest rate for the first few years. That's often a low"teaser" rate.
Thatintroductory period typicallylasts between three to 10 years. After that,the loan converts to aconventional mortgage. The interest rate may increase and the monthly payment must also cover some of the principal. That increases the payment significantly. Some interest-only mortgages require the borrower to pay off the entire balance after the introductory period.
Note
Interest-only loans are also called exotic loans and exotic mortgages. Sometimes they are called subprime loans even though they weren't only targeted to those with subprime credit scores.
Advantages of Interest-Only Loans
The first advantage is that the monthly payments on an interest-only mortgage are initially lower than those of a conventional loan. Thatallows borrowers to afford a more expensivehome.
That only works if the borrower plans to make the higher payments after the introductory period. For example, someincrease their income before the intro period is over. Others plan to sell the home before the loan converts. The remaining borrowers refinance to a new interest-only loan, but that doesn't work if interest rates have risen.
The second advantage is that a borrower can pay off an interest-only mortgage faster than a conventional loan. Extra payments go directly toward the principal in both loans. But, in an interest-only loan, the lower principal then generates a slightly lower payment each month. In a conventional loan, it reduces the principal, but the monthly payment remains the same. Borrowers can pay off the loan faster, but they don't realize the benefit until the end of the loan period. An interest-only loan allows borrowersto realize the benefit immediately.
The third advantage is the flexibility an interest-only loan provides. For example, borrowers can use any extra money, such as bonuses or raises, to apply toward the principal. That way, they don't notice a difference in their standard of living.If they lose their jobsor have unexpected medical costs, theycan go back to paying just the interest amount. That makes an interest-only loan superior to a conventional mortgage for disciplined money managers.
Disadvantages of Interest-Only Loans
First, interest-only loans aredangerous for borrowers who don't realize the loan will convert. They often cannot afford the higher payment when the teaser rate expires. Others may not realize they haven't got any equity in the home and if they sell it, they get nothing.
The second disadvantage occurs for those who are counting on a new job to afford the higher payment. When that doesn't materialize, or if the current job disappears, the higher amount is a disaster. Others may plan on refinancing, but if interest rates rise, they can't afford to refinance, either.
The third risk is if housing prices fall. That hurts homeowners who plan to sell the house before the loan converts.In 2006, when the housing boom ended, many homeowners weren't able to sell because the mortgage was worth more than the house. The bank would only offer a refinance on the new, lower equity value. Homeowners that couldn't afford the increased payment were forced to default on the mortgage. Interest-only loans were a big reason so many people lost their homes.
Types of Interest-Only Loans
There were many types of subprime loansbased on the interest-only model.Most of these were created after 2000 to feed the demand forsubprime mortgages. Banks had started financing their loans withmortgage-backed securities. These derivatives became so popular they created a huge demand for the underlying mortgage asset. In fact, these interest-only loans are part ofwhat really caused the subprime mortgage crisis.
Here is a description of these exotic loans. Their destructiveness means that many are no longer available.
- Option ARM loansallowed borrowers tochoose their monthly payment amount for the first five years.ARM stands for adjustable-rate mortgage.
- Negative amortization loansadded to, rather than subtractedfrom, the principal each month.
- Balloon loansrequired the entire loan to be paid off after five to sevenyears.
- No-money-down loansallowed the borrower to take out a loan for the down payment.
The Bottom Line
Interest-only home loans can be useful to borrowers who are informed about how they work and disciplined about managing their money. If you're not sure if you could afford the monthly payment once your monthly payments increase, you may be a better fit for another type of mortgage.
FAQs
The biggest drawback of an interest only mortgage is that you don't pay off the loan as you go. This means you have to find another way to do this – you can't just forget about it.
Are interest-only loans a good idea? ›
Benefits of an interest-only mortgage
These loans allow the borrower to make larger purchases that they would otherwise only be able to afford a few years down. Thus, interest-only loans might be a wise investment if you are expecting a significant income boost in the coming months and years.
What are some of the risks a borrower could face obtaining an ARM interest-only mortgage? ›
Your payments may go up a lot— as much as double or triple—after the interest-only period or when the payments adjust. negative amortization. Your payments may not cover all of the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.
What is an example of an interest-only loan? ›
Example of an interest-only mortgage
Say you obtain a 30-year interest-only loan for $330,000, with an initial rate of 5.1 percent and an interest-only term of seven years. During the interest-only period, you'd pay roughly $1,403 per month.
Why are interest-only loans risky? ›
Interest-only mortgages carry risks, as borrowers do not build equity during the initial period and face higher payments when transitioning to principal and interest payments. It is important to consider the long-term affordability and potential fluctuations in interest rates.
What is a main disadvantage of the interest-only loan? ›
Interest rates can go up: Interest-only loans usually come with variable interest rates. If rates rise, so will the amount of interest you pay on your mortgage.
How hard is it to get an interest-only loan? ›
Lenders may have more stringent requirements: There may be higher down payment requirements, and it may be more difficult to qualify for an interest-only mortgage with regards to your credit score. You'll also need to demonstrate that you'd be able to repay the loan even when the monthly payment increases.
How long can you have an interest-only loan for? ›
So what is an interest-only home loan? Simply put, borrowers only have to pay the interest for the period as well as any fees for a fixed period of time, usually five to 10 years. Therefore, during this period, the repayments are a lot lower compared to a principal and interest home loan.
What is the riskiest type of loan? ›
What are high-risk loans?
- Secured loans: These loans require you to put up an asset, such as your car or house, as collateral to secure the loan. ...
- Car title loans: This type of secured loan requires you to give your car title over to the lender until the loan is repaid (or you forfeit your ownership).
Conventional loans
A conventional loan is any mortgage that's not backed by the federal government. Conventional loans have higher minimum credit score requirements than other loan types — typically 620 — and are harder to qualify for than government-backed mortgages.
Risky loan features: Lenders can't offer artificially low monthly loan repayments in the early years of the loan term or provide loans with risky features. Examples include interest-only loans, balloon payments and negative amortization.
How is an interest-only loan paid? ›
An interest-only mortgage is a loan with scheduled payments that require you to pay only the interest for a specified amount of time. The amount that you owe on the loan does not go down with each payment. Once the interest-only period ends, you may have several options: Paying off the loan balance all at once.
What is an interest-only loan also called? ›
Interest-only loans are also called exotic loans and exotic mortgages. Sometimes they are called subprime loans even though they weren't only targeted to those with subprime credit scores.
What is different about interest-only loan? ›
An Interest Only home loan means you only repay the monthly interest on the amount borrowed for a set term of one to five years. No repayments are required to reduce the principal amount borrowed, which means the loan balance doesn't reduce.
Why would anyone want an interest-only mortgage? ›
For first-time home buyers, an interest-only mortgage also allows them to defer large payments into future years when they expect their income to be higher. However, just paying interest also means that the homeowner is not building up any equity in the property—only the repayment of principal debt does that.
How do I get out of an interest-only mortgage? ›
There are a few options that you can consider using as a suitable repayment strategy:
- Sell your property. ...
- Switch to a capital repayment mortgage. ...
- Make overpayments. ...
- Savings. ...
- Pension lump sum. ...
- Equity release.
There were 702,000 pure interest-only homeowner mortgages outstanding at the end of 2022, 6.9 per cent fewer than in 2021. In addition there were 222,000 partial interest-only (part and part) homeowner mortgages outstanding at the end of 2022, 11.9 per cent fewer than in 2021.
How long can you have an interest-only mortgage? ›
A typical interest only mortgage lasts between five and 25 years. It's possible to remortgage to a new deal at any time, which is often a good idea if interest rates have changed. You can also remortgage at the end of the deal – but you will need to meet affordability criteria.
