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What Is an Interest-Only Mortgage?

By Austin Kilham · September 30, 2021 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is an Interest-Only Mortgage?

If you’re in the market for a home loan, one of the options you may encounter is the interest-only mortgage. These loans let you pay just the interest for a set period of time, normally five to 10 years.

After that, you’ll need to start repaying both the principal and interest. So your monthly payments are likely to start off low and could end up significantly higher.

Here’s how interest-only mortgages work.

Types of Interest-Only Mortgages

There are two types of interest-only mortgages: fixed-rate and adjustable-rate mortgages. Here’s a look at the two options.

Fixed-rate Interest-Only Mortgages

Fixed-rate interest-only home loans are rare. With a fixed-rate mortgage you lock in an interest rate at the beginning of a loan period, and that rate does not change. These can be particularly useful tools when interest rates are low, as they allow you to guarantee that low rate over the course of the loan.

With a fixed-rate interest-only loan, you’ll pay a fixed interest rate during the interest-only period. After that, you’ll continue making payments at the same rate while adding in principal payments.

Recommended: What is considered a “good” mortgage rate?

Adjustable-Rate Interest-Only Mortgages

The most common interest-only loan programs today are adjustable-rate mortgages. ARMs often start out with a fixed rate that is adjusted after an initial period, often three to 10 years, based on current interest rates. New rates may be higher or lower depending on the interest rate environment.

This type of interest-only ARM is often referred to as a hybrid.

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, while the “1” describes how often the rate will adjust after that. 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 begin paying principal plus interest for the remaining 20 years, and the interest rate will continue to adjust annually.

The loan agreement generally sets maximum and minimum rates. The initial, yearly, and lifetime rate caps can vary depending on the loan program.

If you’re considering taking out an interest-only ARM, it’s a good idea to weigh the above factors as you shop for interest rates, compare the length of interest-only periods, note when rates can be adjusted and the rate caps at each adjustment, and whether the loan has any prepayment penalty.

It’s important to read ARM disclosures carefully and ask for clarification on anything you are not sure of.

Recommended: How does a 5/1 ARM work?

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, the appraisal fee, and the title insurance premium.

That said, perhaps the most important thing to understand when considering the cost of an interest-only mortgage is that you will likely end up paying more in interest than you would with a mortgage that’s fully amortized from the start with no interest-only period.

By paying only interest for years, your loan balance remains untouched.

Who Might Want an Interest-Only Loan?

An interest-only mortgage may have its perks, but these loans also come with risks that borrowers should be aware of. You may want to consider one of these loans if:

You need short-term cash flow. A very low payment during the interest-only period could help free up cash flow. For example, perhaps you can only afford a low payment for the next several years because you’re starting a family. But after that, you’re confident that your income will rise enough that you’ll be able to afford the full mortgage payment.

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 property that they’ll move into full time when they retire in a few years and sell their home.

Interest-only mortgages can have downsides, including:

Potentially higher payments than a conventional loan. During the interest-only period, you’re not putting a dent in your loan principal. Depending on interest rates, your monthly payments after the initial period could be higher than they would be with a conventional fixed-rate mortgage.

Your mortgage could go underwater. Since you’re not gaining equity in your home by paying down your mortgage, you could find yourself owing more than your house is worth if home values decline.

Rates are unpredictable. The 1-Year LIBOR rate, a common benchmark interest rate index used to make adjustments to ARMs, is considered one of the more volatile indexes. (The London Interbank Offered Rate was formalized in 1986 to provide financial institutions with benchmarks for setting interest rates. Every day, 18 international banks submit ideas of the rates they think they would pay if they borrowed money from another bank on the interbank lending market in London. An average is calculated after the four highest and four lowest submissions are removed.)

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Qualifying for an Interest-Only Loan

Interest-only mortgages are nonqualified, meaning Fannie Mae and Freddie Mac don’t back them. The Federal Housing Administration, Veterans Affairs, and U.S. Department of Agriculture don’t offer them either, so they can be hard to come by.

As with any mortgage, lenders considering you for an interest-only home loan will review factors like credit history, 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 loan payments after the interest-only period. They may require high credit scores and a large down payment to qualify for an interest-only mortgage.

The Takeaway

An interest-only mortgage, usually an ARM, could make sense in certain situations, 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 interested in a fixed-rate home loan, investment property loan, or refinance of an interest-only mortgage, SoFi offers a range of mortgage opportunities.

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