Interest-Only Loan: Definition, Pros, Cons, Types

While we adhere to strict

editorial integrity,

this post may contain references to products from our partners. And they may have better uses for their money during the interest-only period that they come out ahead in the long run. Those other uses may come with additional risk that the average homeowner can’t afford to take on, however. Most mortgages require you to pay both interest and principal each month. In this scenario, your overall principal mortgage balance declines every month which means the interest charged is lower the following month.

Before joining LendingTree, Katie spent more than a decade as a developmental and copy editor, where she edited content in a variety of fields, including finance, business, economics, science and education. Since simple interest is calculated only on the principal, it is easier to determine than compound interest. Simple interest is based on the original principal amount of a loan or deposit. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.

The cons of an interest-only loan

You may make principal payments during the interest-only period if you choose. Requirements for an FHA loan are much looser than those of a conventional loan. You can qualify with fair credit, a 3.5% down payment and a higher debt-to-income ratio. You can even use an FHA loan to finance a multi-family rental property or a fixer upper. However, keep in mind that you’ll need to pay mortgage insurance on an FHA loan, which can drive up your overall cost.

You will never pay less each month unless your interest rate adjusts lower. Of course, when homes stopped appreciating in value, many borrowers were stuck with mortgage payments well beyond what they could afford. What’s worse, as the bursting of the real estate bubble pulled the U.S. economy into recession, it also caused many homeowners to lose their jobs, making repayment even more difficult. As rising interest rates make home loans more expensive, an interest-only mortgage might look like a good way to lower your monthly payments. 5/1 traditional ARM–The monthly payment stays at $1,126 for 5 years but

then changes with the interest rate. In the example, the monthly payment would be $1,344 if interest rates

rose 2% in year 6.

Some people think interest-only mortgages are inherently risky, but that’s not always the case. Learning the pros and cons of an interest-only mortgage will help illustrate this point. If you’re interested in keeping your month-to-month housing costs low, an interest-only loan may be a good option. Common candidates for an interest-only mortgage are people who aren’t looking to own a home for the long-term — they may be frequent movers or are purchasing the home as a short-term investment. For example, if you take out a $100,000 interest-only ARM at five percent, with an  interest only period of 10 years, you’d have to pay about $417 per month (only towards the interest) for the first 10 years.

Understanding a Fully Amortizing Payment

The process of separating the principal and interest on a debt obligation is known as stripping. A mortgage-backed security (MBS) that goes through this process—separating the interest and principal payment streams—is referred to as stripped MBS. Compound interest is often a factor in business transactions, investments, and financial products intended to extend for multiple periods or years. Typically, simple interest is used for loans of a single period or less than a year. Compound interest, on the other hand, is based on the principal amount and the interest that accumulates on it in every period.

Lindsay Frankel is a full-time freelance writer and editor with more than 5 years of experience in the personal finance space. She covers credit cards, debt management, travel, shopping, and consumer advocacy topics for multiple finance publications. Another reason why borrowers might take out an interest-only loan is to buy a vacation home, the idea being to sell their existing home in short order (3-5 years) and then move into their second home permanently. They would then use the sale of the family home to pay off the interest-only mortgage on the vacation home. An interest-only mortgage allows them to get more house for their money. It also keeps their housing costs down for a short period of time, possibly in order to invest money elsewhere.

NerdWallet’s Best Interest-Only Mortgage Lenders of 2023

That means you’re not building equity in the house except from your down payment or any gain in value that may occur due to local market circumstances. It is a niche product, best suited for borrowers with strong cash flow, good credit and often for those looking for a short-term loan — typically from five to seven years. These loans offer an introductory fixed rate for three, seven, or 10 years respectively, after which they adjust annually. Other ARM structures exist, such as the 5/5 and 5/6 ARMs, which also feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively.

• This handy guide will help you decide exactly how much of your income you can reasonably dedicate to mortgage payments every month.
• Zero-coupon Treasury strips are an important building block in many financial calculations and bond valuations.
• We’re transparent about how we are able to bring quality content, competitive rates, and useful tools to you by explaining how we make money.
• The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments.

The second disadvantage occurs for those who are counting on a new job to afford the higher payment. When that doesn’t materialize, or if the current job disappears, the higher amount is what is a trial balance a disaster. Others may plan on refinancing, but if interest rates rise, they can’t afford to refinance, either. Interest-only loans are also called exotic loans and exotic mortgages.

Pros of Interest-only Mortgages

Following that period, you can either refinance, pay the remaining balance in a lump sum or begin making regular monthly payments. Here’s everything you need to know about how they work and how you can qualify. An interest-only adjustable-rate mortgage (ARM) is a type of mortgage loan in which the borrower is only required to pay the interest portion owed each month for a certain period of time. During the interest-only period, only interest accrued each period must be paid, and a borrower is not required to pay down any principal owed.

• 5/1 interest-only ARM–The monthly payment stays at $960 for 5 years but

  increases to $1,204 in year 6.

• You may end up paying more for your loan over time than if you had taken out a regular mortgage.
• After their interest-only periods ended, they owed more on their homes than they were worth, and many couldn’t afford the higher principal-and-interest payments.
• Keep in mind, however, that your lender may apply a prepayment penalty to recoup any lost interest if you decide to pay a loan off early.
• In contrast, an I-O payment plan allows

  you to pay only the interest for a specified number of years.

Loans for which fully amortizing payments are made are known as self-amortizing loans. Mortgages are typical self-amortizing loans, and they usually carry fully amortizing payments. Homebuyers can see how much they can expect to pay in interest over the life of the loan using an amortization schedule provided by their lender. With a 30-year fixed-rate mortgage for the same amount, you’d pay $1,881 per month. This includes principal and interest, and also accounts for the higher rate on this type of loan, in this case 5.54 percent.

After that, your monthly payment will increase–even if interest rates

stay the same–because you must pay back the principal as well as the interest. For example, if you take out a 30-year mortgage loan

with a 5-year I-O payment period, you can pay only interest for 5 years and then both principal and interest over the next 25 years. Because you begin to https://online-accounting.net/ pay back the principal, your payments increase after year 5. A fully amortizing payment refers to a type of periodic repayment on a debt. If the borrower makes payments according to the loan’s amortization schedule, the debt is fully paid off by the end of its set term. If the loan is a fixed-rate loan, each fully amortizing payment is an equal dollar amount.

The national average interest-only mortgage rate is not as widely available like other popular 30-year fixed, 15-year fixed and 5/1 ARM rates are. You may have to shop multiple lender websites to get a general idea of rates. It’s also important to note that if you don’t pay any principal, you don’t accumulate equity, unless the market value of your home goes up. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. Simple interest is better for borrowers because it doesn’t account for compound interest. On the other hand, compound interest is a key to building wealth for investors.

What are some important target dates in an I-O mortgage or a payment-option ARM?

Your interest rate can also be affected by how much you borrow, how often you make payments and how long you have to repay your loan. Monthly payments depend on your interest rate and whether the interest rate adjusts during the repayment period or is locked at a fixed percentage of the balance. It’s important to remember that during the interest-only period, your equity balance won’t change.