Understanding interest-only loans: Pros, cons, and when to consider

When you’re exploring your options for taking out a mortgage, you may have run across lenders that offer interest-only home loans. What exactly are they, and are they the right choice for you?

Interest-only loans: What you need to know

• Interest-only loans are a type of mortgage that require you to only pay interest on the loan for a specified period, typically between 5 and 10 years.
• At the end of this period, your loan converts to an amortization schedule where you begin to pay back the principal amount as well as interest.
• Though interest-only loans may give you a lower initial monthly payment, they come with risks that are important consider.

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

An interest-only loan allows you to pay back only the interest on your loan for a set length of time, typically 5 to 10 years. At the end of that period, the amount of principal owed is amortized over the remainder of the loan term and payments are adjusted accordingly. You may make principal payments during the interest-only period if you choose.

Amortization example

If you have a $300,000 mortgage with a 30-year term and made interest-only loan payments for 10 years, that $300,000 will be amortized for the last 20 years of the loan. This will result in an increase in your payments.

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 = $1,875 per month
• Amortized payments for 20 years = $2,417 per month

By comparison, a conventional mortgage for $300,000 with a traditional amortization schedule for 30 years and 7.5% interest would have monthly payments of $2,098.

Pros of interest-only loans

Taking out an interest-only mortgage may be right for you if you are looking for the following benefits:

1. Lower initial monthly payments: During the interest-only period, you will have lower monthly payments as you are only required to pay the interest portion of the loan. This can be particularly beneficial for borrowers with irregular income or who expect their income to increase in the future.
2. Flexibility: Interest-only loans offer you more choice in how you want to make your mortgage payments — you can stick with interest-only payments or choose to make additional principal payments during the interest-only period to reduce the principal balance and lower future monthly payments.
3. Tax benefits: In some cases, the interest paid on a mortgage loan may be tax-deductible. This can provide you with a potential tax advantage during the interest-only period, but make sure to consult with a tax advisor to understand what options may be available to you.

If you plan to sell a property before the end of the interest-only period in an area where home values are likely to increase during that time, you might decide to take out an interest-only home loan as an investment opportunity.

Cons of interest-only loans

1. Higher interest rates: Interest-only loans typically come with higher interest rates compared to fully amortizing mortgages. Lenders 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, the monthly payments will increase as you start paying both principal and interest. This can lead to payment shock, especially if you have not prepared or budgeted for the higher payments.
3. Negative amortization risk: If the interest-only loan has a variable interest rate, there is a risk of negative amortization. This happens when the monthly interest payment is less than the interest accrued on the loan, causing the unpaid interest to get added to the amount you owe. When this happens, you might wind up paying more on your mortgage than your home is worth.
4. Limited equity buildup: Since the principal balance remains unchanged during the interest-only period, you will build little to no equity in your property unless it appreciates in value or you make extra principal payments.

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 non-traditional income: Buyers who rely on commission or bonuses may want to have a lower monthly payment and then pay on the principal when they receive their additional income. People who own businesses with fluctuating revenue may also prefer this type of loan, so they can pay the principal in a large sum without worrying about higher payments each month.
• Borrowers with expected income increases: Recent college graduates and other borrowers who might expect a dramatic increase in their income may want to have a lower monthly payment for a period, expecting their income to rise and afford the amortized payment at the end of the interest-only period.
• Borrowers with confidence in their investments: Someone with confidence in their ability to invest the extra cash they have available from making lower initial monthly payments on their mortgage to generate a higher return than the interest rate on the loan may be interested in this option.

Risks of an Interest-Only Loan

One of the major risks in an interest-only loan is that the buyer may not be able to afford the higher payments when they take effect. To avoid this issue, you can provide a larger down payment and/or pay additional principal whenever possible to lower the balance before re-amortization occurs.

As mentioned above, buyers might plan to sell the property before the interest-only period has ended, with the idea that it will appreciate so they can pay off the loan and still have money for a new home. The risk in this strategy is that the house may not increase in value as expected.