How Interest-Only Mortgages Work

If you want a monthly payment on your mortgage that’s lower than what you can get on a fixed-rate loan, you might be enticed by an interest-only mortgage. By not making principal payments for several years at the beginning of your loan term, you’ll have better monthly cash flow.

But what happens when the interest-only period is up? Who offers these loans? And when does it make sense to get one? Here is a short guide to this type of mortgage.

At its most basic, an interest-only mortgage is one where you only make interest payments for the first several years – typically five or ten – and once that period ends, you begin to pay both principal and interest. If you want to make principal payments during the interest-only period, you can, but that’s not a requirement of the loan.

You’ll usually see interest-only loans structured as 3/1, 5/1, 7/1 or 10/1 adjustable-rate mortgages (ARMs). Lenders say the 7/1 and 10/1 choices are most popular with borrowers. Generally, the interest-only period is equal to the fixed-rate period for adjustable-rate loans. That means if you have a 10/1 ARM, for instance, you would pay interest only for the first ten years.

On an interest-only ARM, after the introductory period ends, the interest rate will adjust once a year (that’s where the “1” comes from) based on a benchmark interest rate such as LIBOR plus a margin determined by the lender. The benchmark rate changes as the market changes, but the margin is predetermined at the time you take out the loan.

Interest-rate changes are limited by rate caps. This is true of all ARMs, not just interest-only ARMs. The initial interest rate cap on 3/1 ARMs and 5/1 ARMS is usually two, says Casey Fleming, a loan officer with C2 Financial Corp in San Diego and author of "The Loan Guide: How to Get the Best Possible Mortgage." That means if your starting interest rate is three percent, then as the interest-only period ends in year four or year six, your new interest rate won’t be higher than five percent. On 7/1 ARMs and 10/1 ARMs the initial rate cap is usually five.

After that, rate increases are usually limited to two percent per year, regardless of what the ARM’s introductory period was. Lifetime caps are almost always five percent above the loan’s starting interest rate, Fleming says. So if your starting rate is three percent, it might increase to five percent in year eight, seven percent in year nine and max out at eight percent in year ten.

Once the interest-only period ends, you’ll have to start repaying principal over the rest of the loan term — on a fully-amortized basis, in lender speak. Today’s interest-only loans do not have balloon payments; they typically aren’t even allowed under law, Fleming says. So if the full term of a 7/1 ARM is 30 years and the interest-only period is seven years, in year eight, your monthly payment will be recalculated based on two things: first, the new interest rate, and second, the repayment of principal over the remaining 23 years.

Fixed-rate interest-only mortgages are not as common. With a 30-year fixed-rate interest-only loan, you might pay interest only for ten years, then pay interest plus principal for the remaining 20 years. Assuming you put nothing toward the principal during those first ten years, your monthly payment would jump substantially in year 11, not only because you’d begin repaying principal, but because you’d be repaying principal over just 20 years instead of 30 years. Since you aren’t paying down principal during the interest-only period, when the rate resets, your new interest payment is based on the entire loan amount. A $100,000 loan with a 3.5 percent interest rate would cost just $291.67 per month during the first ten years, but $579.96 per month during the remaining 20 years (almost double).

Over 30 years, the $100,000 loan would cost you $174,190.80 — calculated as ($291.67 x 120 payments) + ($579.96 x 240 payments). If you’d taken out a 30-year fixed rate loan at the same 3.5 percent interest rate (as mentioned above), your total cost over 30 years would be $161,656.09. That’s $12,534.71 more in interest on the interest-only loan, and that additional interest cost is why you don’t want to keep an interest-only loan for its full term. Your actual interest expense will be less, however, if you take the mortgage interest tax deduction.

Since so many borrowers got in trouble with interest-only loans during the bubble years, banks are hesitant to offer the product today, says Yael Ishakis, vice president of FM Home Loans in Brooklyn, N.Y., and author of "The Complete Guide to Purchasing a Home."    

Fleming says most are jumbo, variable-rate loans with a fixed period of five, seven or ten years.  A jumbo loan is a type of non-conforming loan. Unlike conforming loans, non-comforming loans aren’t usually eligible to be sold to government-sponsored enterprises, Fannie Mae and Freddie Mac — the largest purchasers of conforming mortgages and a reason why conforming loans are so widely available.  

When Fannie and Freddie buy loans from mortgage lenders, they make more money available for lenders to issue additional loans. Non-conforming loans like interest-only loans have a limited secondary mortgage market, so it’s harder to find an investor who wants to buy them.  More lenders hang on to these loans and service them in-house, which means they have less money to make additional loans. Interest-only loans are therefore not as widely available. Even if an interest-only loan is not a jumbo loan, it is still considered non-conforming. 

Because interest-only loans aren’t as widely available as, say, 30-year fixed-rate loans, “the best way to find a good interest-only lender is through a reputable broker with a good network, because it will take some serious shopping to find and compare offers,” Fleming says.   

(Learn more in Fannie Mae: What It Does and How It Operates.)

“The rate increase for the interest-only feature varies by lender and by day, but figure that you will pay at least a 0.25 percent premium in the interest rate,” Fleming says.    

Similarly, Whitney Fite, president of Angel Oak Home Loans in Atlanta, says the rate on an interest-only mortgage is roughly 0.125 to 0.375 percent higher than the rate for an amortizing fixed-rate loan or ARM, depending on the particulars.

Here’s how your monthly payments would look with a $100,000 interest-only loan compared with a fixed-rate loan or a fully amortizing ARM, each at a typical rate for that type of loan:

• 7-year, interest-only ARM, 3.125 percent: $260.42 monthly payment
• 30-year fixed-rate conventional loan (not interest-only), 3.625 percent: $456.05 monthly payment         
• 7-year, fully amortizing ARM (30-year amortization), 2.875 percent: $414.89 monthly payment

At these rates, in the short term, an interest-only ARM will cost you $195.63 less per month per $100,000 borrowed for the first seven years compared with a 30-year fixed-rate loan, and $154.47 less per month compared with a fully amortizing 7/1 ARM. 

It’s impossible to calculate the actual lifetime cost of an adjustable-rate interest-only loan when you take it out because you can’t know in advance what the interest rate will reset to each year. There isn’t really a way to ballpark the cost, either, Fleming says, though you can determine the lifetime interest rate cap and the floor from your contract. This would allow you to calculate the minimum and maximum lifetime cost, and know that your actual cost would fall somewhere in between. “It would be a huge range though,” Fleming says.  

(For further reading, see 5 Risky Mortgage Types to Avoid.)    

Interest-only mortgages can be challenging to understand and your payments will increase substantially once the interest-only period ends. If your interest-only loan is an ARM, your payments will increase even more if interest rates increase, which is a safe bet in today’s low-rate environment. These loans are best for sophisticated borrowers who fully understand how they work and what risks they’re taking.

(Also see Mortgages: Fixed-Rate Versus Adjustable-Rate and Mortgage Basics.)