Everything You Need To Know About Interest-Only Mortgages and How They Work
What is an Interest-Only Mortgage?
Simply put, an interest-only mortgage lets you enjoy lower monthly payments for a set period, usually between 5 to 10 years. During this time, you only have to pay the interest on the loan without having to pay down the principal amount, which makes it attractive for short-term affordability. These loans give you the flexibility to pay down the loan as you see fit and allow you to manage your cash flow with a smaller required payment.
How Do Interest-Only Mortgages Work?
Two different periods make up the borrowing term of an interest-only loan – the interest-only period and the interest & principal period. During the interest-only period, which can be up to 10 years, your monthly payments only cover the interest portion. It’s important to note that your payments will not be going towards any principal, which means you won’t be building any equity at this time. Though, this gives you the unique opportunity to better manage your cash flow by using the additional amounts you would have paid in principal however you see fit. Options include building more cash reserves (dry powder), allocating to other investments, or however else you choose to use this extra cash.
Once the interest-only period ends, you can choose to refinance, pay the remaining balance in full, or begin making fully amortized monthly payments. If you choose to keep the loan, you’ll be required to pay the full payment towards both interest and principal.
How To Calculate An Interest-Only Mortgage Payment
To calculate the monthly payment on an interest-only mortgage, multiply the loan balance by the annual interest rate, then divide that by 12 months.
For example:
Tim purchases a property for $400,000 and chooses to finance it with an interest-only mortgage. He secured an interest rate of 6.5% APR and decided to go with a 5-year interest-only period. For the first 5 years of this loan, Tim will pay:
$400,000 x 6.5% = $26,000 of interest to be paid per year
$26,000 / 12 months = $2,166.67 per month
Who Would Benefit From an Interest-Only Mortgage?
Interest-only mortgages are ideal for those who want flexibility in principal reduction payments or expect an increase in income within the near future. This could include:
- Self-employed individuals
- Freelancers
- High-net-worth individuals
- Contract workers
- Entrepreneurs
- Business owners
- Annual or quarterly commission-based employees
- Real estate investors
- Resident physicians
These loans are also an excellent choice for borrowers who are looking for a way to free up cash, planning to sell or refinance within a short timeframe, or expecting to come into money before the end of the interest-only period.
Interest-Only Mortgages vs. Conventional Mortgages
There are generally two key differences between an interest-only mortgage and a conventional mortgage.
Firstly, interest-only mortgages are typically considered to be non-qualified mortgage (non-QM) loans, meaning they aren’t required to follow the guidelines set by Fannie Mae and Freddie Mac. Whereas a conventional mortgage has to follow these rules, resulting in stricter eligibility criteria and less flexible loan terms.
Secondly, interest-only mortgages are structured to have an interest-only period of 3 to 10 years at the beginning of the loan term, which allows borrowers to have a lower monthly payment. In contrast, a conventional mortgage requires both interest and principal to be paid each month.
Interest-Only Mortgage Loan Terms
Specific interest-only mortgage terms will vary depending on the lender, but here’s what we offer at Defy:
- Loan amounts up to $10M+
- Up to 85% LTV
- Interest-only fixed rates of 5/7/10 years
- No requirement for a principal paydown
- 30-year or 40-year loan amortization
- Primary, second, or investment properties allowed
Interest-Only Mortgage Interest Rates
Interest rates for interest-only mortgages vary by lender and your individual borrower profile. Generally, you can expect them to fluctuate in tandem with conventional mortgage rates. However, due to the unique nature of interest-only mortgages, interest rates for these loans may be slightly higher than for conventional loans.
Pros and Cons of Interest-Only Mortgages
Pros:
- Flexibility to manage your cash flow on your own terms
- Fixed rates
- Pay only the interest on the loan during the initial period
- No requirement for a principal paydown
- Pay off the mortgage as you see fit
- Lower monthly payments allow borrowers to pursue other investments or have “dry powder” on hand
- An opportunity to “date the rate and marry the property”
Cons:
- Higher overall interest costs
- Limited availability
- Payments get larger after the interest-only period ends
- Risk of negative equity
Alternatives to Interest-Only Mortgages
If you find that an interest-only mortgage isn’t for you, consider these non-QM alternatives:
- Bank statement loans
- Profit & loss (P&L) loans
- Asset depletion options
FAQs
- What is an interest-only mortgage?
An interest-only mortgage is a type of mortgage that allows borrowers to only pay the interest on the loan for a set initial period, typically 5-10 years. This results in lower monthly payments during this initial period.
- How do interest-only mortgages work?
With an interest-only mortgage, your monthly payment only covers the interest that accrued on the loan amount. This means that the principal balance isn’t reduced during the interest-only period.
- How long do you pay only the interest on an interest-only mortgage?
The initial interest-only period on an interest-only mortgage depends on the specific loan terms. However, common interest-only periods are 5, 7, or 10 years.
- What happens when an interest-only mortgage ends?
After the interest-only period ends, the mortgage transitions to a repayment phase, which means that your monthly payment will start to cover both interest and principal. This results in larger monthly payments in comparison to the initial period. However, other options include: refinancing the loan, selling the property, or finding a way to pay off the remaining principal balance.
- Can you refinance an interest-only mortgage?
Yes, you can refinance an interest-only mortgage.
- What are the loan terms for an interest-only mortgage with Defy Mortgage?
Here are the loan terms we offer for an interest-only mortgage with Defy:
- Loan amounts up to $10M+
- Up to 85% LTV
- Interest-only fixed rates of 5/7/10 years
- No requirement for a principal paydown
- 30-year or 40-year loan amortization
- Primary, second, and investment properties
- Where can I get an interest-only mortgage?
Compared to traditional mortgages, interest-only mortgages aren’t as widely offered. Look for lenders who specialize in non-QM loans, like us at Defy, since they are more likely to offer alternative loan options.
- Who should get an interest-only mortgage?
Interest-only mortgages are ideal for someone who needs lower initial monthly payments and is expecting future income growth or plans to sell the property before the repayment phase. This could include students, resident physicians, or real estate investors.
- Can you get an interest-only mortgage if you’re self-employed?
Yes! You can get an interest-only mortgage if you’re self-employed.
- What are the interest rates for an interest-only mortgage?
Interest rates for an interest-only mortgage will depend on the lender’s terms and your financial profile.
- Do I need a down payment for an interest-only mortgage?
Yes, a down payment is typically required for an interest-only mortgage.
- How big of a down payment do you need for an interest-only mortgage?
The specific down payment requirements may vary between lenders, but you can expect to put down anywhere between 10% to 30% of the property’s value. At Defy, we require a minimum of 15% down for our interest-only loan programs.
- What are the pros and cons of an interest-only mortgage?
Pros:
- Lower monthly payments initially
- Can be helpful for short-term affordability needs
- A viable option for those who expect their income to increase soon
- Provides the opportunity for homeownership
- Flexibility for those who are self-employed or can’t provide traditional income documents
Cons:
- Potential for significantly higher monthly payments after the initial interest-only period
- Higher overall interest costs
- Not building equity on the home during the initial interest-only period
- What’s the difference between an interest-only mortgage and a conventional mortgage?
Interest-only mortgages provide much more flexibility with their loan terms and qualification requirements. They allow self-employed individuals to qualify with the option to pay only the interest on the loan (no principal paydown required). Conventional loans require traditional income documentation to qualify and give borrowers no choice but to pay both principal and interest every month.
- Can you get an interest-only mortgage for an investment property?
Yes! You can get an interest-only mortgage for an investment property.
- What should I consider before getting an interest-only mortgage?
There are a few factors to consider before getting an interest-only mortgage:
- Your long-term goals: Determine how you plan to reallocate the principal portion that you would normally pay. You can take this portion and use it for other investments, your business, another property, or another opportunity.
- How will an interest-only mortgage fit into your long-term plans: At the end of an interest-only period, your monthly payments will become fully amortized, meaning you’ll be responsible for both the interest and principal each month. Halfway through your interest-only period, keep an eye on interest rates if you plan to refinance or plan for what you’ll do if you still have the loan at the end of the interest-only term.
- Pay attention to home values: If your home value appreciates, you can still benefit from this whether you pay the principal or not. However, if your home value depreciates, you may end up with negative equity in the home, which can lead to difficulties in refinancing.
