How Does an Interest-Only Home Loan Work?

Some home buyers want to secure the lowest monthly payment possible. One way to do this may be through an interest-only loan. This type of loan can offer a lower rate initially, but it is somewhat of a unique structure requiring careful consideration before investing. In this loan, a property owner will pay just the interest on their home loan, without paying any of the principal on the loan.

How Does an Interest-Only Home Loan Work?

When a lender allows a homeowner to purchase real estate using an interest-only home loan, they will be setting up terms that require several things. First, these loans will allow the property owner to pay just interest for several months or years, depending on the agreed-upon terms. During this time, which can be as long as five to ten years in some cases, the monthly payment is significantly lower because none of the principal is paid.

The principal is the amount the homeowner borrows to buy the property. This is often the amount of the sale price minus any down payment the buyer made. In refinancing a loan, the principal is the amount that is still owed to the lender – the amount the homeowner needs to borrow from the lender I the transaction.

The principal remains the same during the interest-only period. Once that period ends, the homeowner will begin to make larger payments that are combined interest and principal payments. The homeowner can make principal payments during the interest-only period if they desire to do so. Doing so can help to reduce interest costs and the overall length of the term. However, this is not a requirement in this type of funding structure.

How Interest-Only Mortgages Are Structured and Interest Rates

When considering an interest-only mortgage, homeowners will often see them expressed in a format such as 7/1 or 10/1. These are often adjustable-rate mortgages. The most commonly used versions are 7/1 and 10/1, but they can also include 3/1 and 5/1. In all cases, the first number represents the timeframe for when the interest rate remains fixed during the loan. In a 7/1 example, the “7” represents the length of time that the interest-only loan will maintain a fixed interest rate. That means that for the first seven years, the homeowner will pay a fixed monthly payment – one that remains the same.

The second number displays how often the interest rate will change after that introductory period. In this case, it has a “1.” That means that after the first 10 years of a fixed rate, the interest rate can adjust one time every year until the mortgage ends.

It is rather common for all types of adjustable-rate mortgages to adjust each year like this. However, how much it changes depends on various factors, including the changes in the federal interest rates. Most often, the loan will follow a benchmark rate in how it adjusts. Generally, this is the LIBOR rate. If that rate increases, the adjustable-rate mortgage rate will grow. Keep in mind that it adjusts based on that rate, but there is nearly always an additional margin added to it.

When it comes to an interest-only mortgage loan, it’s important to realize that these loans will see the interest rate adjust throughout the lifetime. During the interest-only period, most loans have a fixed rate. Then, they tend to adjust upward as the LIBOR rate adjusts (with some additional costs). As a result of this, homeowners will need to take into consideration the actual cost of their monthly mortgage payment will increase significantly over the lifetime of the loan in many cases.

What Are the Benefits of an Interest-Only Mortgage?

There are some key reasons some people will want to use an interest-only mortgage to purchase a home. While consumers should consider all loan options before making a purchase, an interest-only mortgage is not one that is to be easily overlooked. Consider these key benefits.

Lower Monthly Payments

The most common option is that it will create very low monthly payments during the fixed-rate term period. Because the homeowner does not have to pay principal payments, it reduces the actual cost of the monthly payment significantly.

Lower Payments Mean Buying Power Increases

Because the mortgage loan payments are lower, many people using an interest-only loan will see a significant improvement in the amount of money they can borrow from their lender to buy a home. As a result of this, it may be possible for a buyer to qualify for a higher-valued home than if they were to apply for a traditional conventional loan with standard, fixed-rate interest.

This occurs as a result of the way lenders calculate the amount a person can borrow based on their monthly income. They will gather information about the home buyer’s income and then determine how much of a loan payment they can afford. Most lenders follow a debt-to-income ratio closely that is set in-house. Because the interest-only mortgage loan has a lower monthly payment, the borrower can often borrow a significantly higher amount of money to meet the debt to income ratio.

However, consumers need to be sure they can afford the monthly payment not just during the initial period of the loan where there is a fixed rate, but later on when they are paying interest and principal. There is some added risk here to the consumer about these loans if there is any doubt that the buyer may not be able to afford the larger payment that comes down the road.

Interest-Only Mortgage Loans Free Up Cash Flow

Another key reason why interest-only mortgage loans can work for some home buyers is that it can help to free up some cash flow. For example, with a lower monthly payment, the consumer has more money in hand to use for anything they need. They may be able to use these funds to pay down other debt or to invest in stocks and bonds. Of course, the homeowner can use his or her income for any need, but it can also be a powerful tool in reducing what they owe on the loan.

For example, if the homeowner decides to pay down some of the principal on the loan while making just interest-only payments, that can reduce the overall costs. However, they still have the flexibility not to do this when their income drops, or they have a higher expense to pay down the road. Because it gives more flexibility in using funds the way it works for the homeowners’ needs, a financially savvy home buyer will want to take a look at why interest-only mortgage loans like this can work for them.

Ideal Investment Loans

In some cases, a homebuyer may want to purchase a property, but they do not plan to own it for a long time. For example, a homebuyer may wish to buy and flip the home – doing some repairs to add value to the property before reselling it. This type of investment strategy works very well because it means the investor buying the home does not have to spend as much money on monthly mortgage payments. Most would plan to sell the home within that fixed interest, initial period, reducing their need to pay back the principal until the home was sold.

This benefit can work for other homebuyers as well. For example, if a person knew he or she was only going to live in an area for a few years, they may not need a long term commitment in the home. They may secure an interest-only mortgage loan, pay the lower monthly payments during that initial term, and sell the home before the second portion of the loan becomes apparent. Keep in mind that these loans may need to have eliminated prepayment penalties form the terms – a fee that is charged if the loan is paid off in full before the due date.

Careful Considerations for Interest-Only Loans

There are some outstanding benefits to interest-only loans, but they can be somewhat risky in situations where the end goal is not met. For example, if the example above of the homebuyer that plans to move shortly does not play out, and the homeowner must remain in the home longer, then he or she would be required to make those higher payments. This increase to principal and interest payments can be substantial. If the homebuyer cannot afford this higher payment, he or she may want to avoid using this type of loan.

Also, note that some types of interest-only loans will have balloon payments. This is a specific, larger amount of money that needs to be paid at a later date. Because it is a large amount of money, it may be hard for the homeowner to pay for it. That is something that the consumer needs to work on when choosing this type of loan.

Another key concern occurs when there is an underwater situation. Being underwater on a home loan means that the borrower owes more on the loan than the property is worth. This can happen in some cases, especially if the local mortgage is not performing as well as it used to, and home values drop.

How to Choose an Interest-Only Mortgage

For those who are considering the value of an interest-only mortgage, one of the first steps is to speak to a lender that offers them – not all do. Then, the homebuyer will need to go through the same qualification process of obtaining a loan, as is considered normal. Once this is done, it is important to look at all of the terms associated with the loan.

One key way to understand what is going to occur within the loan over its lifetime is to view the amortization calculator and schedule. This document will breakdown the monthly payments at the start of the loan and for each monthly payment throughout the lifetime of the loan, assuming a specific interest rate. By looking at this, the homebuyer can understand better, what he or she can expect when the fixed-rate period ends, and principal payments begin.

It is also important to understand that adjustable rates mean that mortgage payments can rise above this. It is possible to see payments remain the same during the first portion of the loan period – during the fixed-rate period. However, most will adjust year to year after that as the benchmark rate changes.

It may be possible to find a fixed-rate interest-only mortgage. These are typically less common, but they can provide the homebuyer with more understanding of what they will pay over the entire life of the loan. With this type of loan, the interest rate remains the same throughout the entire period, but the homeowner only pays interest on the loan for the first portion.

Consumers also need to understand the terms, including how long they will pay just interest and the interest rate they qualify for. Be sure to consider whether a prepayment penalty is in place or any type of balloon payment.

By comparing the costs of interest-only mortgages to other forms of loans and comparing the short-term and long-term goals of the homebuyer, it may be possible to better understand if an interest-only loan is a good fit for their needs. The costs include the fees to purchase the loan, interest rates on the loan, and the cost of maintaining the loan long term.

For those who are considering interest-only mortgages, it is quite important to work with an educated and experienced lender, one that can break down the comparable for these loans well to demonstrate what is to be expected. While interest rates right now are low, many consumers may benefit from a fixed-rate loan for their full mortgage loan term. In all cases, these loans are one option, and they may work for a variety of borrowers to create lower monthly payments and easier qualifications for the loan purchase.