Interest-Only Mortgage

What is 'Interest-Only Mortgage'

An interest-only mortgage is a type of mortgage in which the mortgagor is required to pay only interest with the principal repaid in a lump sum at a specified date.

BREAKING DOWN 'Interest-Only Mortgage'

Interest-only mortgages can be structured in various ways. Paying only the interest is a provision that may be available for some borrowers. Interest-only payments may be made for a specified time period, may be given as an option or may last throughout the duration of the loan.

Interest-Only Mortgage Advantages

Interest-only mortgages reduce the required monthly payment for a mortgage borrower by excluding the principal portion from a payment. Homebuyers have the advantage of increased cash flow and greater support for managing monthly expenses. For first-time home buyers an interest-only mortgage also allows them to defer large payments into future years when they expect their income to be higher.

If a borrower qualifies for an interest-only mortgage there are multiple ways it can be structured. Most interest-only mortgages require only the interest payments for a specified time period, for example five years. After that, the loan converts to a standard schedule and the borrower’s payments will increase to include both interest and a portion of the principal. Some interest-only mortgages may include special provisions that allow for only interest payments under certain circumstances. For example, a borrower may be able to pay only the interest portion on their loan if damage occurs to the home and they are required to make a high maintenance payment. In some cases, the borrower may have to pay only interest for the entire term of the loan which requires them to manage accordingly for a one-time lump sum payment.

Paying Off the Loan

While an interest-only mortgage requires the borrower to make only interest payments, they still must pay the entire loan principal at some point. At the end of the interest-only mortgage term, the borrower has a few options. Some borrower’s may choose to refinance their loan after the interest-only term has expired which can provide for new terms and potentially lower interest payments with principal. Other borrowers may choose to sell the home to payoff the loan. Many borrowers choose to individually save the principal on the loan in order to make a one-time lump sum payment when the loan is due.

While interest-only mortgage loans can be convenient for a number of reasons they may also add to default risk. Borrowers should cautiously estimate their expected future cash flow in order to ensure that they are able to payoff the loan when required.