Is an interest-only mortgage a good idea for you, or will it cost you more in the long run? Read what our experts say about this type of mortgage now.
There is no doubt that an interest-only mortgage could be the best option available to you. Maybe you are a student who expects to make a high salary someday, you inherit a lump sum, or you do not expect to live on the property for a long time.
But there are also very real risks. Here is everything you need to know about interest-only mortgages—both when they are a good idea and when they are not. To our audience of mortgage professionals, please pass this article along to a client who is considering an interest-only mortgage.
For an interest-only mortgage, you make repayments only on the interest on the principal amount borrowed. This arrangement is made for a set term, such as five years, for example. During that period, you pay nothing off the principal, meaning the principal does not reduce until that set term ends.
When the interest-only period concludes, your loan will change from an interest-only mortgage to a principal and interest loan. When this happens, you start making payments for the principal amount and the interest on that amount, meaning your payments increase.
How an interest-only mortgage works
Most interest-only mortgages are structured as an adjustable-rate mortgage (ARMs). Your ability to make interest-only payments typically lasts no longer than 10 years, after which you begin repaying on both the principal and the interest on the principal. The principal is repaid either as a lump sum or through payment plans.
Here is an example of how an interest only mortgage would work:
- You have a $100,000 interest-only adjustable-rate mortgage at 5%.
- If you have an interest-only term of 10 years, you will have to repay roughly $417 each month, which only goes toward the interest for the first 10-year term.
- After those 10 years, you will have to pay the principal and the interest on the principal, raising your monthly payments substantially.
Why would you get an interest-only mortgage?
This is a fair question. It may seem like it would be overwhelming to only be paying interest for up to 10 years and then have the principal amount—with interest—looming over you.
Interest-only mortgages are good for anyone who wants to keep their month-to-month housing costs low. Usually, anyone who wants to own a home for a shorter term would be interested in interest-only mortgages. Maybe you are a frequent mover, for example, or are purchasing a property for the short-term investment.
It is also a viable option if you want to purchase a second property to eventually make your primary residence. If you are not permanently residing in the property quite yet, making payments toward the interest only will be financially beneficial.
However, you should know that interest-only mortgages can be difficult to get approved for, unless you have significant savings, a low debt-to-income ratio, and high credit scores.
If you already have an interest-only mortgage, there are some things you might want to consider:
- Can you switch to a repayment mortgage?
- Should you pay into an investment plan?
- Should you make lump-sum repayments?
- What are your remortgage options?
Here is a breakdown of each:
1. Can you switch to a repayment mortgage?
This consideration is important if your financial situation changes and it makes sense. In this case, you may want to look at remortgaging.
2. Should you pay into an investment plan?
A good approach to repaying your mortgage may be investment in shares, stocks or other financial products. Since there are so many products on the market, some could pose more of a risk to your financial well-being than others. So do your research, which should include speaking with an independent financial advisor, prior to making your decision.
3. Should you make lump-sum repayments?
It wouldn’t be a bad idea, especially if you get a lump sum suddenly, such as an inheritance. But verify ahead of time that your lender will not penalize you for doing so.
4. What are your remortgage options?
You may want to switch to a repayment mortgage, which is relatively straightforward with the right mortgage technology, or look for another interest-only mortgage. Interest-only mortgages usually come with an initial rate between two and 10 years. After that period, you will be placed on the lender’s standard variable rate, which is not that competitive. Before your deal comes to a close, it is important to know what options are available to you.
There are numerous benefits of an interest-only mortgage, especially for homebuyers who are confident they will be able to make larger payments in the future but need to save in the short term.
Here is a quick look at some examples of when an interest-only mortgage will be advantageous for you:
- Your income increases
- You want to qualify for a larger property
- You are navigating a soaring housing market
- As an investment strategy
- For tax deductions
- You want to pay equity on your schedule
Let’s take a more in-depth look at each.
1. Your income increases
Taking out an interest-only mortgage would be worth it to keep your homebuying costs down during a time when your income is low but is expected to increase in the foreseeable future, for instance, if you were in law school and wanted to purchase a property. Most of your money would be wrapped up in tuition. However, making higher mortgage payments 5-10 years in the future should be no issue.
2. You want to qualify for a larger property
This will work best if you have a large lump sum coming to you in the future, such as an inheritance. But be careful; it can also be difficult to secure a home loan based primarily on this future money. It is also important that it is a sure thing, since your mortgage payments will grow significantly when your interest-only period ends. You will have to be prepared for that.
3. You are navigating a soaring housing market
This may be a good way to purchase a property when house prices are high. You would use an interest-only mortgage to purchase a home you would be otherwise unable to buy with a conventional mortgage and sell, or flip, the property after a few years. This strategy can backfire, however, if the housing bubble bursts, so it is important to know the risks going in.
4. As an investment strategy
An interest-only mortgage may be right for you if you have a healthy stock portfolio but are reluctant to sell investments to make mortgage payments or would prefer to invest your money in equities or a retirement plan.
5. For tax deductions
Interest paid on mortgages above a certain amount ($1 million, say) are often tax deductible. If you have a substantial income and you are in a high tax bracket, an interest-only mortgage and deduction might be helpful to lowering your income tax payment. Remember, in this case, your whole mortgage payment would be tax deductible and not merely a portion of it.
6. You want to pay equity on your schedule
Usually, you will not be prohibited from making payments to lower your principal on most interest-only mortgages. It could also decrease your monthly interest payment, making it a good option if your income is variable and you are able to pay more some months.
On the other hand, there are downsides to interest-only mortgages. If you are unable to pay a higher monthly mortgage payment when the principal is introduced, interest-only mortgages can be risky.
Here are some examples of when interest-only mortgages may be too risky to pursue:
- There is no growth in equity
- Home values are decreasing
- The riskier the loan, the higher the interest rate
- Variable interest rates jump
Here is a closer look at each:
1. There is no growth in equity
So that lenders have collateral against default, most interest-only mortgages typically require you to make a significant down payment. It also means, however, that for the first 10 years of your mortgage, you do not grow any equity at all—unless you want to make extra payments. Interest-only mortgages are probably not the best idea if your goal is to pay down your mortgage.
2. Home values are decreasing
The disadvantage of interest-only loans was made quite clear during the 2008 housing market meltdown. Many homebuyers took out interest-only loans, which increased home prices; but when the housing bubble burst, the prices plummeted, leaving interest-only mortgage holders with high interest payments on properties in which they had very little equity.
Read more: How to calculate your home equity
3. The riskier the loan, the higher the interest rate
Interest-only mortgages were once easy to sell to other financial institutions. Now, they are not so marketable. Lenders want bigger down payments and charge more interest on interest-only mortgages than on conventional mortgages, which are considered less risky.
4. Variable interest rates jump
Most interest-only mortgage have variable interest rates, which adjust with a benchmark funds rate. If those fund rates increase, the amount of interest you pay on your mortgage or you home equity line of credit (HELOC) increase. Therefore, you might be better off securing a loan that lets you lock and unlock the interest rate. That would allow you more certainty around future payments.
Remember: you will still be on the hook for the original loan amount when the term of your interest-only mortgage comes to an end. But do not worry—there are options. Here are three:
- Remortgage. You can take out another mortgage—either repayment or another interest-only mortgage—to repay your first interest-only mortgage. You will still need to ensure that you meet a lender’s criteria. This is good to keep in mind since you will have grown older, and your life circumstances could be different.
- Sell the home. To repay your interest-only mortgage, you could simply sell your home, which usually makes sense if you buy to let. Hopefully, your property price will pay for the entire loan amount with some remaining. If, on the other hand, you are less lucky, you may run into negative equity and be forced to pay for the shortfall.
- Pay with investments/savings. You may be able to use funds you have earned from investments and/or savings to pay off your interest-only mortgage.
What happens if you can’t repay an interest-only mortgage?
If, at the end of the term, you fear you will be unable to repay your interest-only mortgage, there are some options available to you. At a quick glance, those options are:
- Overpay on the mortgage
- Move to a repayment mortgage
- Extend the term of your mortgage
- Once again, sell your home
Here is a closer look at each:
Overpay on your mortgage
Should you choose to overpay on your mortgage, you will want to make sure there are no early repayment charges. If not, it would be wise to overpay on your interest-only mortgage and start paying off the principal as soon as possible. If you suddenly come into money, such as from an inheritance, this is an especially good option.
Move to a repayment mortgage
This will be your best bet if the lump sum that you will be expected to pay at the end of your interest-only mortgage term becomes too daunting. Moving into a repayment mortgage will help you make payments on the principal sooner. If you do opt for this, however, you can expect your monthly payments to increase significantly. Just ensure you will still be able to meet those payments.
Extend the term of your mortgage
Let’s be clear here: if you extend the term of your mortgage, you are essentially attempting to buy yourself more time. It may, however, provide you with enough breathing room–i.e., time and money—to repay the balance. Note: In certain circumstances, such as surpassing a certain age, you may be ineligible to extend your mortgage.
Selling your property is both something you could do simply to repay your interest-only mortgage as well as something you are forced to do if you run out of options. If the property has not fallen into negative equity (i.e., become worth less than the amount you owe on the loan) then you should be able to sell and settle the mortgage. We have some tips on how to sell your house quickly if you are in this situation.
Have experience with an interest-only mortgage? Tell us about it in the comment section below.