How Do Interest-Only Loans Work? A Simple Guide For Smart Buyers

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If you’re in the market to buy a home and you’re not planning to pay cash, chances are high that you’ve either already spoken with a lender or you’re planning to do so in the near future. While there may be limited wiggle room with your budget and credit history, your lender is a valuable resource when it comes to determining an effective loan strategy for the purchase of your new home.

There are numerous types of loans and financing programs available, but today we’re focusing on one that is perhaps lesser-known and certainly harder to find: the interest-only mortgage loan.

With expert advice from Richie Helali from HomeLight Home Loans, we’re taking a deep dive into the world of interest-only loans — from how they work, to who they’re right for, and everything in between.

Let’s do this.

Understand what are interest only loans
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So, what is an interest-only mortgage, and how does it work?

Put simply, this is a mortgage where you’ll only pay interest for the first several years. This introductory period is usually either 5 or 10 years, and your monthly payments will be significantly smaller during this time.

As an example, let’s say you’ve borrowed $250,000 at an interest rate of 3.75%. On a 30-year, fixed-rate loan with an interest-only period of five years, your payment would be $781.25 per month for those first five years. Once the principal payment kicks in, your payment would then go up to $1,285.33 each month for the remaining 25 years of the loan.

Interest-only mortgages are usually adjustable-rate loans. So, while you’ll still have those first years of only having to pay interest, once that period is over, your interest rate will adjust — at the same time you’ll also start paying toward the mortgage principal.

“Let’s say yours happens to be a 30-year loan, with the first 5 years interest-only. After those 5 years, it goes to a 25-year interest and principal, with a fully adjustable rate,” explains Helali. “The rate is typically going to adjust at least once a year on the anniversary of the loan. It could go up by $X amount; it could go down by $X amount.”

If an adjustable rate sounds a little scary, don’t fret — there’s going to be a rate cap that you will have agreed to at the time of the loan, and it’ll protect your monthly payment from skyrocketing.

As the FDIC explains, “If your loan has a payment cap of 7.5%, your monthly payment won’t increase more than 7.5% from one year to the next, even if interest rates rise more than 7.5%.”

Do be aware, though, that this rate cap merely caps your actual monthly payment. You’re not off the hook for the additional interest. Whatever interest you don’t pay as a result of your payment cap will be added to the balance of the loan.

This means that you’ll probably prefer a fixed-rate interest-only loan; just don’t count on finding one at the drop of a hat.

According to Helali, they’re extremely uncommon.

Are interest-only mortgages still available?

They are technically available from certain lenders, but they’re pretty rare. These loans are riskier for lenders, and since they’re considered to be non-conforming loans, interest-only mortgages do not meet Fannie Mae and Freddie Mac guidelines. Thus, most lenders just don’t offer or support this type of loan — especially after the Great Recession.

Today, “these loans are normally something that is available to folks who are private clients or have a really good relationship with their bank,” says Helali.

It’s worth asking about if you’re on good terms with the local branch of your preferred bank or credit union, but you’re probably not going to find an interest-only mortgage on the list of available services at an institution you’ve just signed up with.

You’ll also be fighting a losing battle if you’re hoping to qualify for an interest-only loan with a distressed credit score; there’s simply too much risk involved. A top-notch credit history is a must.

One advantage of interest only loans is savings
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Advantages of interest-only mortgages

If you can find (and qualify) for one, an interest-only loan can offer several financial advantages:

First, having several years’ worth of lower monthly payments frees up your cash flow for investments, business ventures, big savings goals, home renovations, or anything else you choose.

You also may be able to afford a more expensive home. While many hopeful buyers focus on saving up lots of money for a down payment, your buying power is often strongest when interest rates are low — sometimes it’s best to strike while the iron is hot. And if you’re only paying interest for the next several years, you can instead funnel the cash that would have gone toward a larger mortgage payment right back into your own savings, should you choose to do so.

It’s easier to get (and stay!) ahead on your mortgage with an interest-only loan if you’re planning on paying down your principal, too. You’ll need to read the fine print of your loan agreement, as some mortgages may be structured with a prepayment penalty — your lender can help clear up any confusion — but generally speaking, the more you can afford to pay each month, the quicker your balance will reduce. If you can contribute to both your interest-only loan and the loan balance, then your balance will dwindle more quickly. And the lower the balance, the less you’ll end up paying in interest, too.

You can likely refinance. Again, check your loan terms to avoid penalties, but you usually have the option of refinancing your home as you approach the end of your interest-only period, so long as you qualify and have sufficient equity in the home. This means you can reap the benefits of years of lower payments, then refinance to a more conventional loan to pay off the rest of your mortgage.

Disadvantages of interest-only mortgages

There are indeed some potential downsides to be aware of with interest-only loans:

You might pay a higher interest rate to offset the lender’s risk. Your initial monthly payment will almost certainly still be lower than it otherwise would (thanks to having that 5- or 10-year buffer before starting payments toward the principal), but if walking out of the bank with the lowest possible interest rate is your priority, an interest-only loan may not be the best route for you.

During the introductory period, you won’t build equity by paying down your loan principal. Ideally, your home’s value will still appreciate within the overall real estate market, netting you some equity, but you won’t have decreased your loan principal.

You could end up underwater with your mortgage, particularly if market conditions are unfavorable and your home actually loses value during the interest-free introductory period.

It’s easy to forget that your reduced payment is only temporary. Your monthly payments will increase significantly, so if you bite off more than you can chew with your home, or if your financial situation changes unexpectedly, you could find yourself in a sticky situation when the clock runs out on your intro period.

There may be a prepayment penalty — and the definition of “prepayment” can take many forms. As we touched on before, it’s important to know your loan terms. Helali warns that, to a certain extent, banks are free to add restrictions to these unconventional loans.

“If they want to, they can organize the program to have a three-year prepayment penalty; meaning that within those first three years, [the buyer] will be unable to pay off, sell, refinance, pay down, or any combination thereof without being subject to a penalty.

“Not all banks have these, but it’s something to watch out for.”

Are interest only loans a good idea?
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Are interest-only loans actually a good idea?

This is one of those pesky “it depends” situations, where the specifics of your lifestyle and financial means really come into play.

For most buyers, especially those who are risk-averse, interest-only loans probably are not the best option.

These loans are rare for a reason — they’re risky for the lender, yes; but they’re risky for the buyer, too. For many of us, it’s difficult to accurately predict where we’ll be financially in 5 or 10 years; and it’s equally difficult to predict future interest rates and real estate market conditions. Even if your interest-only loan terms allow for eventual refinancing, there’s no guarantee that a new mortgage will be as favorable as you may have hoped.

How do I know if an interest-only mortgage is right for me?

There are a few criteria you can examine to help determine if pursuing an interest-only home loan is a good idea for you:

How’s your financial situation? As we’ve mentioned, you’ll need strong credit to qualify for this type of loan, along with a stable (and preferably higher-than-average) income, plus a cushion of cash reserves or other assets. Speaking broadly, interest-only loans are mostly for high-earning individuals who want to free up cash for investments.

How long are you planning to live in the home? Not everyone buys a house with “forever” in mind. If you know you’re only going to stick around for a few years, an interest-only mortgage can be a great tool for keeping payments as low as possible on a property you have no intention of owning for the next 30 years.

What are your other financial priorities? Since only having to pay the interest frees up hundreds of dollars each month, this type of home loan can be very convenient if you’re in the midst of a financial transition.

Maybe you’re saving for a child’s college education or fixing up a second home — whatever the case, if you need to keep some cash at the ready, paying as little as possible on your primary mortgage can be a great way to achieve this flexibility.

How do you find interest only loans?
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How can I find an interest-only home loan?

If you’ve ticked all the boxes and you’re feeling like an interest-only mortgage is actually right for you, now begins the quest of tracking one down.

Your best bet? Start with someone you know.

“The drawback of these loans is that they’re hard to find,” Helali reminds us again. “And in the banks that do offer them, typically they’re going to want you to have some sort of preexisting relationship with that bank.”

If you don’t have a longstanding relationship with a bank that offers interest-only loans, you can always try networking. There’s power in referrals, so if you have a friend or colleague whose financial institution offers this type of loan, and that person is willing to make an introduction and vouch for you, this can be a way to get a foot in the door.

You can also speak with your real estate agent, who likely maintains relationships with a number of mortgage lenders and can help point you in the right direction.

Then, of course, there’s the internet. There are countless financial platforms across the web that can offer information, and perhaps even the loan itself. Just be sure to proceed with caution and carefully read through every document to ensure that you have a full understanding of the terms and conditions of the loan.

“There are no stupid questions,” says Helali.

“You’re spending hundreds of thousands of dollars — or millions, in some cases — on a home, so ask! Even if you feel it’s a dumb question, who cares? Ask the question.”

Enjoy those interest-only payments, but don’t lose focus

If you like the idea of an interest-free home loan, and you’re able to find and qualify for one — great! You’ll open yourself up to unique financial opportunities and have extra flexibility in your month-to-month budget.

Buying a home always takes planning and forethought, but thinking ahead is especially important when your mortgage payments can and will fluctuate. Proceed accordingly!

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