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.

How the Payments Work

At its most basic, an interest-only mortgage is one where you only make interest payments for the first several years – typically 5 or 10 – and once that period ends, you 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 10 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 3%, then, when the interest-only period ends in year four or year six, your new interest rate won’t be higher than 5%. On 7/1 ARMs and 10/1 ARMs the initial rate cap is usually five.

After that, rate increases are usually limited to 2% per year, regardless of what the ARM’s introductory period was. Lifetime caps are almost always 5% above the loan’s starting interest rate, Fleming says. So if your starting rate is 3%, it might increase to 5% in year eight, 7% in year nine and max out at 8% in year 10.

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.

A Less Common Interest-Only Loan

Fixed-rate interest-only mortgages are not as common,  though you’ll find them through Bank of America if you need a jumbo loan (a loan for an amount greater than $417,000)  or through Navy Federal Credit Union for both conforming loans (loans typically limited to $417,000 in most parts of the country) and jumbo loans. To join Navy FCU, you’ll need to be affiliated with the U.S. Armed Forces, Department of Defense, Coast Guard or National Guard or be related to a Navy FCU member.   (See Jumbo vs. Conventional Mortgages: How They Differ.)

With a 30-year fixed-rate interest-only loan, you might pay interest only for 10 years, then pay interest plus principal for the remaining 20 years. Assuming you put nothing toward the principal during those first 10 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% interest rate would cost just $291.67 per month during the first 10 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% interest rate (mentioned in “How the Payments Work,” 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.

Loan Availability

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 First Meridian Mortgage 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 5, 7 or 10 years.  A jumbo loan is a type of nonconforming loan. Unlike conforming loans, noncomforming loans aren’t eligible to be sold to Fannie Mae and Freddie Mac, the two giant institutions that are 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. Nonconforming loans like interest-only loans have a limited secondary mortgage market; 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 nonconforming. (Learn more in Fannie Mae: What It Does and How It Operates.)

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.   

In addition to Bank of America, Navy FCU and the companies our expert sources work for – C2 Financial Corp, First Meridian Mortgage and Angel Oak Home Loans — other lenders we found that offer interest-only loans include EverBank,  Union Bank’s Private Bank,  marketplace lender SoFi,  Citizens Bank, Bank of Internet  and United Wholesale Mortgage. This isn’t an exhaustive list, but it offers a starting point if you’re shopping for an interest-only loan.

Comparing the Costs

“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% 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 0.125% to 0.375% 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%: $260.42
  • 30-year fixed-rate conventional loan (not interest-only), 3.625%: $456.05           
  • 7-year, fully amortizing ARM (30-year amortization), 2.875%: $414.89

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, so you could 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.  

The Bottom Line

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

You may also be interested in Mortgages: Fixed-Rate Versus Adjustable-Rate and Mortgage Basics.