What Is an Interest-Only Mortgage?

How Interest-Only Mortgages Work

An interest-only mortgage is structured in two phases:

• An initial period typically lasting three to 10 years, during which you pay only interest on the loan principal
• An amortization phase, during which you make payments toward both interest and principal on the loan

During the amortization phase, payments are structured much as they would be with a traditional mortgage: A high percentage of the early payments go toward interest charges and a relatively small fraction covers principal (and accumulates home equity). The balance gradually shifts over time, so that by the end of the payment term, payments consist almost entirely of principal payments, with just a small portion going toward interest.

Note that the amortization phase of an interest-only loan typically spreads principal payments over a considerably shorter span period than comparable conventional mortgages would: On a 30-year $300,000 interest-only mortgage with a 10-year interest-only phase, for instance, principal payments are spread out over a 20-year period, which means they are typically much higher than they'd be on a comparable conventional loan, with principal payments are spread across all 30 years of the loan term.

Here's an example:

Let's say you're buying a $400,000 home with a 20% down payment of $80,000. That'd mean you're borrowing $320,000. If you get a 30-year interest-only mortgage with a 10-year initial term and an annual percentage rate (APR) of 6.8%:

Your initial monthly payment (excluding property taxes, insurance and other fees) would be:
(6.8% x $320,000) = $1,813.

Assuming you make no extra payments during the interest-only phase of the loan term, your payments once you reach the amortization phase will essentially be the same as if you'd taken out a $320,000 conventional mortgage with a 20-year term at 6.8% APR. Excluding property taxes, insurance and other potential fees, the Experian Mortgage Calculator shows that your monthly payment would climb to about $2,443—an increase of almost 35% over the payments you'd make during the interest-only period.

This example assumes the loan has a fixed interest rate, but most interest-only home loans are adjustable-rate mortgages (ARMs), with rates that can change annually with fluctuations in a specific benchmark index rate that can vary by loan and lender. In environments with rising interest rates (such as we're seeing in early 2022), monthly payments can increase substantially based on each annual adjustment of an ARM's APR.

Pros and Cons of Interest-Only Mortgages

Pros

Lower initial payments: During the interest-only phase of an interest-only mortgage, monthly payments are typically lower than those on a comparable conventional mortgage, which include both interest and principal.

Extra payments can reduce payment amount: If you can afford to make extra payments on an interest-only mortgage, applying those payments against the loan principal can lower the amount of your monthly payments. During the initial phase of an interest-only loan, interest is calculated on the outstanding principal on the loan, so applying extra payments toward principal will lower interest charges and bring down monthly payments. Reducing outstanding principal during the loan's interest-only phase can also lower the size of the payments you'll be charged once the loan converts to the amortization phase.

Use of principal amount for other investments: A chief appeal of interest-only mortgages for buyers with significant wealth is the ability to invest funds that would otherwise go toward principal payments on the a home loan: Some buyers' funds may be tied up in 401(k) funds or individual retirement accounts (IRAs) they cannot access without penalty at the time of the home purchase, but which they will be able to use by the end of the mortgage term. Other buyers would rather sink funds into investments that they expect to yield greater returns than what they'll pay in interest on a mortgage-only loan.

Ability to buy more house: The initial low payments on an interest-only loan may allow you to finance more house than you could afford if you had to make the full principal-plus-interest payments required with a conventional mortgage on the same property. Eventually, however, an interest-only mortgage will have higher payments, so it's important to plan for them.

Potential tax advantages: Mortgage interest of up to $1 million per year is deductible from federal income taxes. Depending on your tax bracket, savings on your taxes during the initial phase of the repayment term could significantly offset the amount of your interest-only mortgage payments.

Cons

Higher total interest costs: Over the initial phase of an interest-only mortgage, interest-only payments are based on the full loan amount. That's a contrast to conventional mortgage amortization that gradually reduces interest charges and increases principal payments over the life of the loan. That means that you'll end up paying more interest overall than you would with a conventional mortgage with the same APR.

Deferred home equity: Unless you make extra payments that apply toward loan principal, you accumulate no home equity during the interest-only portion of the loan term, so it's impossible to get a home-equity loan or line of credit on the property during that time.

Major payment increase: When an interest-only mortgage converts to an amortized payment structure, the size of the monthly payment increases significantly. The exact amount of this increase can be difficult to anticipate unless you have a fixed-rate loan, and the bump in payment amount can present a major budgeting challenge.

Lack of predictability: Most interest-only mortgages are adjustable-rate mortgages (ARMs), with rates that typically change annually, based on shifts in posted market indexes or prevailing interest rates. This can affect the amount of your monthly payments over the entire term of the loan.

Strict lending requirements: Lenders are compelled by law to ensure you can repay the full loan amount at the end of an interest-only mortgage term, so they'll look closely at your finances and will want to see assets, investments or retirement savings that can be converted to sufficient cash to cover the loan amount. This makes it relatively difficult to qualify for an interest-only mortgage.

Higher down payments and interest rates: Lenders consider interest-only mortgages riskier than conventional loans, and therefore may insist on higher down payments and higher interest rates to offset the extra risk of issuing them. Interest-only mortgages are not considered qualified mortgages, which means they are ineligible for government-backed mortgage programs such as FHA Loans, VA Loans and USDA Loans, and are available from fewer lenders than conventional mortgages.

How to Qualify for an Interest-Only Mortgage

A couple of decades ago, a lender might have issued an interest-only loan on the assumption that you could cover some or all of the loan amount by selling the house, but the 2008 financial crisis brought plunging home values and stagnant home sales that left many interest-only borrowers unable to cover their loans, and regulations tightened to prevent that from happening again.

Interest-only mortgages became extremely scarce in the years following the 2008 crisis, and are still far from common. Contact lenders in your area to ask about interest-only loans or work with a real estate agent who may be able to connect you with a lender that provides them.

Regulations imposed after the crisis have lenders verify borrowers' ability to repay all loans, so you should expect any lender to take a close look at your finances, and to require an explanation of how you plan to pay off the loan, including how you'll manage the transition from the interest-only phase of the loan term to the costlier amortization period. That could include providing evidence that your income is expected to increase over the loan's initial phase or proving that you'll have access to savings or investments when loan terms change.

Other requirements will vary by lender, but they are also likely to require:

• A strong credit score (FICO^® Score^☉ of 700 or better)
• A low debt-to-income (DTI) ratio of 36% or lower

Alternative Mortgage Options

Conventional mortgage: Qualifying for an interest-only loan is difficult by design, so if you find yourself unable to meet the steep lending requirements involved, consider seeking a conventional mortgage loan. The relatively higher monthly payments may mean you'll have to consider a less costly home than the one you'd prefer, but the overall cost of a conventional loan is considerably lower than that of an interest-only mortgage, and in a few years you may be able to trade up to a pricier home.

Jumbo loan: If you are interested in financing a home that's significantly more expensive than the average homes in your county, a jumbo loan may be your only option. Available as both interest-only loans and, more commonly, as conventional repayment mortgages, these nonqualified mortgages are subject to many of the same strict lending requirements as other interest-only loans, so it's unwise to seek one unless you have very good credit, strong cash flow and access to sufficient means to cover such a large loan.

The Bottom Line

The relative scarcity of interest-only mortgage loans, their relatively high costs, and the steep requirements most lenders place on applicants for them make them less than ideal for most borrowers. They are best suited to a rather narrow group of borrowers including:

• Individuals with strong, documentable expectations of major income growth in the foreseeable future (recent graduates of law school or medical school, for example)
• Individuals with access to sufficient assets that can be liquidated to pay the loan if necessary
• People approaching retirement age who will gain access to tax-advantaged funds such as IRAs or 401(k) accounts in time to cover the payment hike on the loan

If you fall into one or more of these groups and an interest-only mortgage works for you, check that your credit is in good shape for mortgage borrowing, and shop carefully, getting rate quotes from multiple lenders to get the best loan terms available to you.