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- For the first few years of an interest-only mortgage term, you'll just pay interest each month; then you'll switch to paying both interest and principal.
- For example, a 10/20 interest-only mortgage requires only interest payments for the first 10 years, and regular monthly payments for the remaining 20 years.
- It can be difficult to qualify for an interest-only mortgage; you'll need a high credit score, low debt-to-income ratio, and minimum 20% down payment.
- You won't build any equity in your home until you start making payments toward the mortgage principal.
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What is an interest-only mortgage?
A mortgage is a loan for buying a home. When you get a regular mortgage, your monthly payments cover two main expenses:
- Principal: This is the amount you borrow from the lender. If you get a mortgage for $150,000, the principal is $150,000. You'll spread the principal out into monthly payments over the entire life of your mortgage.
- Interest: This is the fee the lender charges for borrowing money to buy your home. It's expressed as a percentage, such as 2.88% or 3.75%. Your interest payment is wrapped into your mortgage payment, along with the principal.
(You can also roll other home-related costs over into your monthly mortgage payments, such as property taxes and homeowner's association dues. But the principal and interest are the two expenses associated with actually borrowing money.)
Interest-only mortgage payments work differently from traditional mortgages, though. Each month, you only make payments toward the interest, not the principal.
The interest-only period comes with a short term, usually 10 years or less. Interest-only mortgages are typically adjustable-rate mortgages, or ARMs, meaning the rate stays the same for while, then changes periodically.
For example, you may have a 10/20 interest-only ARM. This means you'll repay your mortgage over 30 years — the first 10 years will be interest-only payments, and the remaining 20 will be payments toward both the interest and principal. Terms vary by lender, but chances are your adjustable rate will change once per year.
Some lenders provide the option to sign up for a type of balloon mortgage. You'll make interest-only payments for the first few years, then pay the entire principal in one lump sum. This method isn't as common as switching to interest-and-principal payments, though.
Who can qualify for an interest-only mortgage?
Each lender has its own rules surrounding who qualifies for an interest-only mortgage. But in general, requirements are more stringent than for other types of mortgages. You'll probably need at least a 20% down payment and 700 credit score, and your debt-to-income ratio should be low.
Some lenders may require you to have a certain amount in the bank, or want to know about your income potential. They want to see whether you'll be able to afford higher payments later.
Should you get an interest-only mortgage?
Interest-only mortgage pros
- Low monthly payments. The biggest draw of an interest-only mortgage is that you'll pay less each month than if you were putting money toward the principal. Low payments can help you afford a home sooner.
- Good option if you expect to earn more later. This type of mortgage could be useful if you're confident you'll earn more money down the road. For example, you may know you're going to get your annual bonus at the end of the year, or you're due for a raise soon.
- Good option if you have strong finances. First, you need to have an impressive down payment, credit score, and debt-to-income ratio to qualify for an interest-only mortgage. Second, gaining equity in your home shouldn't be a huge part of your burgeoning financial portfolio, because it takes a long time to build equity with an interest-only mortgage. This type of mortgage could be a good fit for people who are buying an investment property rather than a primary residence.
Interest-only mortgage cons
- Adjustable mortgage rates. Most interest-only mortgages come with an adjustable interest rate. Fixed-rate mortgages charge lower rates than adjustable-rate mortgages right now. Because rates are at all-time lows in general, your ARM rate will almost certainly increase down the road.
- Building equity. It takes a long time to build equity with an interest-only mortgage, because you won't make any progress on the principal owed for several years. If you want homeownership to be a significant part of your financial portfolio, an interest-only mortgage isn't a good tool to help you get there.
- Potential to lose equity. Not only will you not build equity during the interest-only period, but you could actually lose equity. The housing market may decline, or your home might lose value for some other reason. For these reasons, getting an interest-only mortgage with plans to sell before the interest-only period ends is risky.
- Monthly payments increase. Yes, you'll make low payments for the first few years of your mortgage term. But keep in mind that you will have to make regular mortgage payments later, and if you don't plan accordingly, you may not be able to afford higher payments.
- Hard to find. Because interest-only mortgages are risky for lenders, not all companies offer them. You may need to spend time finding a lender that offers the terms you want.
You might like an interest-only mortgage if your finances are strong and you're not worried about building equity. Otherwise, you may want to look at another type of mortgage.
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