Interest-only loans: Pros, cons, and when to consider

Please note: Discover® Home Loans does not offer interest-only loans.

When exploring options for taking out a mortgage, you may come across lenders offering interest-only home loans. But what exactly are they, and are they the right choice for you? 

Interest-only loans: What you need to know

• Interest-only loans require you to only pay interest on the loan for a specified period — for example, the first 10 years.
• At the end of this period, you typically pay back the loan principal as well as interest.
• Interest-only loans may offer lower initial monthly payments than a traditional mortgage because you don't have to pay the loan principal during the first period. However, they may come with risks that are important to consider.

What is an interest-only loan and how does it work?

An interest-only mortgage, also known as an interest-only loan, requires you to pay back only the interest on your loan for a set length of time. At the end of that period, the amount of principal owed is typically amortized over the remainder of the loan term, resulting in you paying both interest and principal.

Some lenders give you the option to make voluntary principal payments during the interest-only period. 

Amortization example

Say you have a $300,000 mortgage with a 30-year term and only make interest payments for the first 10 years. The $300,000 is amortized for the last 20 years of the loan.

This will increase your monthly payments after the interest-only period ends.

To get an idea of how much that increase might be, let's say you took out that $300,000 mortgage with a fixed 7.5% interest rate:

• Interest-only payments for 10 years = about $1,875 per month
• Interest and principal payments for 20 years = about $2,417 per month

By comparison, a conventional mortgage for $300,000 with a traditional amortization schedule for 30 years and a 7.5% interest rate would have monthly payments of about $2,098 excluding any taxes, insurances, and other fees.

Pros of interest-only loans

Potential advantages of taking out an interest-only mortgage include:

1. Lower initial monthly payments: During the interest-only period, you may have lower monthly payments than a traditional mortgage as you are only required to pay the interest portion of the loan. 
2. Flexibility: Interest-only loans may offer you more choice in how you make your mortgage payments. You can stick with interest-only payments or, if your lender allows, also make principal payments during the interest-only period. Just keep in mind that not all lenders offer the same repayment options, so make sure you understand your lender's requirements before applying for an interest-only loan.
3. Tax benefits: According to the IRS, the interest paid on a mortgage loan may be tax-deductible due to the home mortgage interest deduction as long as all requirements are met. Make sure to consult with a tax advisor to understand what options may be available to you.
4. Opportunity for profit: An interest-only home loan may be beneficial if you plan to sell the property before the end of the interest-only period.

Cons of interest-only loans

Here are some of the potential disadvantages of interest-only loans:

1. Higher risk: Lenders may consider these loans riskier due to the lack of principal reduction during the interest-only period.
2. Payment shock: Once the interest-only period ends, you typically start paying both interest and principal, resulting in increased monthly payments. This may lead to payment shock, especially if you haven't prepared or budgeted for higher payments.
3. No equity building through principal payments during interest-only period: If you don't make principal payments during the interest-only period, you will build no equity in your property unless it appreciates in value. 

When to consider an interest-only loan

An interest-only loan may be a viable option for borrowers in certain situations, such as:

• Borrowers with variable income: Those who receive commission, bonuses, or other variable income may prefer a lower monthly payment during the interest-only period and, if their lender allows it, the option to make principal payments when they receive these funds.
• Borrowers with fluctuating income: People with income that fluctuates throughout the year may prefer to make principal payments during the loan's initial period when they have the financial means to do so (if this is allowed by their lender).
• Borrowers with expected income increases: Those who expect a future increase in their income, such as college graduates starting their careers, may benefit from this option. They can delay higher payments of interest and principal until the end of the interest-only period when they anticipate being in a stronger financial position. 
• Borrowers with confidence in their investments: This loan option may appeal to borrowers confident they can invest the cash they save from making interest-only monthly payments and generate a higher return than the loan's interest rate. However, this is a high-risk strategy.

Risks of an interest-only loan

One of the risks of an interest-only loan is that borrowers may not be able to afford the higher payments when they take effect. To avoid this issue, they may be able to provide a larger down payment on their home and/or pay principal payments during the interest-only period (if their lender offers this option).

As mentioned earlier, a borrower may plan to sell their property before the interest-only period has ended. If the property increases in value, they may be able to make a profit before any principal payments are due. The risk in this strategy is that the property may not increase in value as expected.

If an interest-only loan isn't the right option, you may want to find a traditional mortgage that works for your situation.