An interest-only mortgage lets you pay just interest for a set period of time, usually three to 10 years, and comes with an initial rate that’s typically lower than that of a 30-year fixed-rate loan.
After the introductory period, if you keep the loan, you’ll need to start repaying both the principal and interest. So your monthly payments are likely to start off low and end up higher.
Here’s how interest-only mortgages work and who might be interested in them.
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Types of Interest-Only Mortgages
There are two types of interest-only mortgages, but one is far more popular.
Adjustable-Rate Interest-Only Mortgage
The most common interest-only loans are adjustable-rate mortgages (ARMs). The hybrid ARM has an introductory fixed rate that then changes to a variable rate for the rest of the term.
The 5/1 ARM has been the most common hybrid adjustable-rate mortgage, but loan seekers have been looking for seven- and 10-year introductory periods as of late.
The 5/1 has a low initial fixed rate for five years, when the borrower will pay just the interest on the loan. Then the rate will adjust once a year — hence the “1” — according to an index and the margin. The index is a measure of interest rates in general. The margin is an extra amount the lender adds, and it remains constant for the life of the loan.
The move toward using the Secured Overnight Financing Rate (SOFR) as the benchmark for setting interest rates on ARMs translates to changes on new loans. SOFR ARM rates will adjust at six-month intervals. If the initial rate is good for five years, for instance, the loan is a 5/6 ARM. And the rate can go up or down no more than one percentage point every six months.
Rate caps dictate how much the rate can adjust. There are usually three:
• The initial adjustment cap.
• The subsequent adjustment cap, for the adjustment periods that follow.
• The lifetime adjustment cap, which dictates how much the interest rate can rise over the life of the loan.
If you’re taking out a new ARM, ask which benchmark your rate will be based on. A SOFR-based rate may be your best bet, as the rate can adjust just one percentage point at every reset period.
Fixed-Rate Interest-Only Mortgage
Fixed-rate interest-only home loans are rare. A borrower locks in an interest rate and pays just interest for a set period, then makes payments at the same rate but adds principal payments.
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Interest-Only Loan Pros and Cons
Pros
Most ARMs start with lower interest rates than those for 30-year fixed-rate mortgages.
That can be appealing to house flippers, people who know they’re going to move before the adjustable-rate period begins, borrowers who expect their income to increase, or those who plan to refinance the mortgage to a fixed rate.
ARM borrowers may be able to afford a more expensive house. A home affordability calculator can also be helpful in determining how much you can spend.
Cons
Borrowers can face payment shock if interest rates increase and their monthly payments rise.
Borrowers can try to refinance before the initial rate adjustment, but market rates may not be as low as they hoped.
During the interest-only period, you’re not putting a dent in the loan principal. Depending on interest rates, your monthly payments after the initial period could be higher than they would have been with a fixed-rate mortgage.
A mortgage could go underwater. Since you’re not gaining equity in your home for a while, you could owe more than your house is worth if home values decline.
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Interest-Only Loan Costs
As with any mortgage, when you take out an interest-only loan, you can expect to pay closing costs, such as the origination fee, appraisal fee, and title insurance.
If you keep an interest-only mortgage, you will likely end up paying more in interest than you would with a mortgage that’s fully amortized from the start.
Interest-Only Mortgage Alternatives
The 30-year fixed-rate mortgage is the most popular with homebuyers by far, because the rate and the principal and interest payment amount will not change for the life of the loan.
Most homebuyers are not in it for the super short term: The typical homeowner spends more than 13 years in their home. (The Los Angeles market claims the longest tenure, at 18 years on average.)
So borrowers have predictability, and the option of paying off the mortgage early.
What about rising rates? A look at historical mortgage rate fluctuations shows that rates have been relatively low for 20 years, nothing like October 1981’s gasp-worthy 18.63%.
Still, ARMs are often much cheaper short term.
Who Might Want an Interest-Only Loan?
You may want to consider one of these loans if:
• You want or need short-term cash flow. A very low payment during the interest-only period could help free up cash.
• You plan to own the home for a short time. If you move frequently or you’re buying a home as a short-term investment, an interest-only mortgage may work.
• You’re buying a second home that you’ll turn into your primary residence. People nearing retirement, for example, might buy a vacation home that they’ll move into full time in a few years and pay off or refinance the interest-only loan.
• You expect to be able to pay off the mortgage before the initial rate adjustment or soon after.
• You expect an income increase or windfall if you’re planning to keep the interest-only loan.
First-time homebuyers may
qualify for a SoFi mortgage loan
with as little as 3% down.
Qualifying for an Interest-Only Loan
ARMs and fixed-rate mortgages have similar qualifying requirements. Lenders considering you for an interest-only home loan will review factors like credit score, down payment, employment, income, assets, and home value.
However, because you plan to make only interest payments for a set period of time, you’ll be building no equity in the home initially, meaning you’ll have less skin in the game. Lenders see this as risky, so they’ll want to make sure you’ll be able to make the loan payments after the interest-only period.
A conventional ARM typically requires a down payment of at least 5%.
An FHA ARM requires 3.5% down if the borrower has a minimum credit score of 580. A VA ARM calls for no down payment.
The Takeaway
An interest-only mortgage, usually an adjustable-rate mortgage, can make sense for some buyers, but a borrower could end up paying much more in interest in the long run compared with having a fully amortized loan.
If you’re looking for a mortgage or a refinance, see what SoFi offers.
SoFi has a range of fixed-rate mortgages for primary homes, second homes, and investment property.
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