If you’re in the market for a home loan, the options can get confusing. Between fixed rates and adjustable rates, terms of 15 or 30 years, and jumbo vs. conforming loans, it can be hard to know which choices are right for you. It’s important to do your homework, but figuring out the best mortgage to take out doesn’t have to be intimidating.
One of the concepts that can be befuddling to many is an interest-only mortgage. No, this doesn’t refer to a home loan that only requires you to pay interest and then forgives the principal. Essentially, interest-only loans let you pay just the interest for a certain fixed period of the loan term.
After that point, you need to start paying both the principal and interest back for loan payoff. So your monthly payments are likely to start off quite low and could end up significantly higher.
Interest-only loans sometimes get a bad rap, because they played a role in the 2007 mortgage crisis .
These loans now come with more safeguards, and they can be an advantageous option for financing a home for some buyers. But it’s important for anyone considering an interest-only mortgage to understand exactly how the loan operates and the terms they’re signing up for.
How an Interest-Only Mortgages Work
When you receive an interest-only mortgage, you have an option to start out by just making interest only payments, usually for an initial period of time, normally ranging from 3 to 10 years .
The most common interest only loan programs today are the Hybrid ARMs. This type of Interest Only (I/O) ARM is referred to as a Hybrid because during the initial period of the ARM loan, the rate is fixed.
After this timeframe, the “introductory rate” ends and the monthly payment converts into full principal and interest payments for the remaining term of the loan. The longer the interest-only period lasts, the higher the monthly payments could be afterward depending upon the principal amount due and interest rate changes.
Some interest-only mortgages have fixed rates, meaning the interest rate itself never changes, however the payment can increase once the interest only period ends and full principal and interest payments are made in order to facilitate loan payoff.
Others can be monthly, semi or annual adjustable rate mortgages (ARMs), meaning the interest rate will likely fluctuate over time, including potentially during the interest-only period.
In other loans, also known as a hybrid or intermediate ARMs, the rate may start out fixed and then become adjustable after the first few years. For example, let’s say you take out a “5/1” interest-only, hybrid ARM for a term of 30 years and an interest-only period of 10 years.
The “5” refers to how many years the rate is initially fixed for, while the “1” describes how often the rate will adjust after the initial fixed rate period. So in this case, you’d have the option to make interest-only payments for the first 10 years, but the interest rate can adjust every year after the first five years.
When the initial 10 years are up, you’ll be paying principal plus interest for the remaining 20 years, and the interest rate will continue to adjust annually.
For example, let’s say on that 5/1 ARM above, the rate is fixed at 4.5% for the first five years.
Once that initial rate period ends, the lender figures out the new rate based on the loan margin defined in your loan documents and an ARM rate index, most commonly the 1-Year Libor (London Interbank Offered Rate Index ). For example, let’s say your loan margin is 2.25%. The 1-Year Libor index has hovered around 2.75% recently = 5% (rounded to the nearest .125%).
If initial rate was 4.5% and initial rate adjustment cap is 3.0%, rate and cap = 7.5% which is higher than the margin and index rate of 5%, therefore the margin and index rate would be used and the initial/annual rate cap would not come into play because the margin and index calculation of 5.0% did not exceed the interest rate cap calculation of 7.5%.
There’s one more concept to understand: the initial interest rate cap. Also defined in your loan agreement, this is the maximum rate that the ARM can reach after the first rate adjustment and this can be different from the subsequent annual adjustment rate caps. So if you had the same loan margin as above of 2.25% but the 1-Year Libor rose to 5.4% , the total calculated rate would be 7.65%.
But the maximum interest rate allowed is 4.5% (your initial rate) plus 3% (the initial rate cap), so the lender could only adjust the interest rate to 7.5%.
The yearly rate cap after the initial adjustment is usually 2%, and it’s good to note that the initial, yearly and lifetime rate caps—or the limit to how much your rate can increase at these times— can vary depending on the loan program. Read your ARM disclosures carefully and ask for clarification on anything you are not sure of.
If you’re considering taking out an interest-only ARM, it may be a good idea to weigh all the above factors when deciding whether to jump in or which lender to go with.
That means comparing not only the length of the interest-only period, but also the loan margin and index, when interest rates can be adjusted and the rate caps at each adjustment. That way, you can get a sense of how much your rate might change over time.
The Pros and Cons of an Interest-Only Mortgage
Paying interest only on a mortgage loan may have its perks, but these loans also come with risks that borrowers should be aware of. A major advantage of these mortgages is having the option of a low payment for the interest only period while helping to free up cash flow in the short-term.
For example, perhaps for the next 10 years, you can only afford a low payment, since you are in graduate school and also starting to have kids.
But after a decade, you are confident that your income will rise enough that you’ll be able to afford the full mortgage payment.
With a hybrid ARM, another benefit can be that the interest rate is fixed for a period between 3 and 10 years , so you know it can’t increase during the fixed rate period.
However, interest-only loans can have downsides. First, because if you’re not paying down the principal during the interest only period, the actual principal loan amount is not going down during that time.
Consequently, depending upon interest rates your monthly payments after the initial period can be higher than they would with a conventional fixed rate mortgage.
Since you’re not gaining equity in your home by paying down your mortgage, you could find yourself underwater (owing more than your house is worth) if home values decline.
The 1-Year Libor Rate, used to determine rate adjustments, is considered one of the more volatile indexes, since it’s tied to real time economic conditions and the flow of the federal funds rate.
These disadvantages are one reason that interest-only loans aren’t very widespread, representing just 1% of mortgages. To help prepare for any increase in rates, run loan payment scenarios with your lender using the highest interest rate cap and loan amount and see if the highest payment calculated is still manageable for you.
Qualifying for an Interest-Only Loan
Just like any mortgage, lenders considering you for an interest-only loan will review factors like credit, down payment, employment income and history, assets, home value and more.
Minimum credit scores, the down payment required, and the maximum qualifying debt-to-income ratio can vary by loan program and lender, though a very good credit score is generally needed. It’s typically harder to qualify for an interest-only loan these days than for a conventional fixed-rate loan and these loans may require a larger down payment mostly because these types of loans are considered more risky.
Beyond an Interest-Only Mortgage
While you may have borrowed a 30-year mortgage with an interest-only payment option with no prepayment penalty, it could be helpful to keep the idea of refinancing in your arsenal.
After the fixed-rate or interest-only portion of the loan ends and the monthly payment has the potential to increase, one option available to borrowers is mortgage refinancing. This could provide an opportunity for borrowers to improve the terms of the loan, or potentially qualify for a lower interest rate.
If you’re interested in refinancing an interest-only mortgage, consider SoFi. The application process can be started easily online and SoFi’s team of mortgage professionals work to make the process as transparent as possible.
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