How Do Interest-Only Loans Work? A Simple Guide For Smart Buyers

Are interest-only mortgages still available?

They are technically available from certain interest-only mortgage lenders, but they’re pretty rare. These loans are riskier for lenders, and since they’re considered to be non-conforming loans, interest-only mortgages do not meet Fannie Mae and Freddie Mac guidelines. Thus, most lenders just don’t offer or support this type of loan — especially after the Great Recession.

Today, “these loans are normally something that is available to folks who are private clients or have a really good relationship with their bank,” says Helali.

It’s worth asking about interest-only mortgage rates if you’re on good terms with the local branch of your preferred bank or credit union, but you’re probably not going to find an interest-only mortgage on the list of available services at an institution you’ve just signed up with.

You’ll also be fighting a losing battle if you’re hoping to qualify for an interest-only loan with a distressed credit score; there’s simply too much risk involved. A top-notch credit history is a must.

Pros and cons of interest-only mortgages

As with any financial decision you make, it is important to weigh the advantages and disadvantages before making a decision. Let’s take a look at the pros and cons of going for a loan that offers interest-only mortgage rates for the first years.

Pros of interest-only mortgages

If you can find (and qualify) for one, an interest-only loan can offer several financial advantages:

• Free up your cash flow. Having several years’ worth of lower monthly payments gives you leeway to use your cash for investments, business ventures, big savings goals, home renovations, or anything else you choose.
• Beef up your savings. If you’re only paying interest for the next several years, you can instead funnel the cash that would have gone toward a larger mortgage payment right back into your own savings, should you choose to do so.
• Afford a more expensive home. While many hopeful buyers focus on saving up lots of money for a down payment, your buying power is often strongest when interest rates are low — sometimes, it’s best to strike while the iron is hot. Plus, the additional cash you’ve saved up can help with the down payment!
• Manage mortgage payments more easily. It’s easier to get (and stay!) ahead on your mortgage with an interest-only loan if you’re planning on paying down your principal, too. You’ll need to read the fine print of your loan agreement, as some mortgages may be structured with a prepayment penalty — your lender can help clear up any confusion — but generally speaking, the more you can afford to pay each month, the quicker your balance will reduce. If you can contribute to both your interest-only loan and the loan balance, then your balance will dwindle more quickly. And the lower the balance, the less you’ll end up paying in interest, too.
• You can likely refinance. Again, check your loan terms to avoid penalties, but you usually have the option of refinancing your home as you approach the end of your interest-only period, so long as you qualify and have sufficient equity in the home. This means you can reap the benefits of years of lower payments, then refinance to a more conventional loan to pay off the rest of your mortgage.

Cons of interest-only mortgages

There are indeed some potential downsides to be aware of with interest-only loans:

• You might pay a higher interest rate to offset the lender’s risk. Your initial monthly payment will almost certainly still be lower than it otherwise would (thanks to having that 5- or 10-year buffer before starting payments toward the principal), but if walking out of the bank with the lowest possible interest rate is your priority, an interest-only loan may not be the best route for you.
• During the introductory period, you won’t build equity by paying down your loan principal. Ideally, your home’s value will still appreciate within the overall real estate market, netting you some equity, but you won’t have decreased your loan principal.
• You could end up underwater with your mortgage, particularly if market conditions are unfavorable and your home actually loses value during the interest-free introductory period.
• It’s easy to forget that your reduced payment is only temporary. Your monthly payments will increase significantly, so if you bite off more than you can chew with your home, or if your financial situation changes unexpectedly, you could find yourself in a sticky situation when the clock runs out on your intro period.
• There may be a prepayment penalty — and the definition of “prepayment” can take many forms. As we touched on before, it’s important to know your loan terms. Helali warns that, to a certain extent, banks are free to add restrictions to these unconventional loans.

“If they want to, they can organize the program to have a three-year prepayment penalty; meaning that within those first three years, [the buyer] will be unable to pay off, sell, refinance, pay down, or any combination thereof without being subject to a penalty.

“Not all banks have these, but it’s something to watch out for.”

Comparison between interest-only loans and traditional fixed-rate loans

Interest-only loans and traditional fixed-rate mortgages differ significantly in how payments are structured, their long-term costs, and suitability for borrowers. Here’s a breakdown of the key differences:

Are interest-only loans actually a good idea?

This is one of those pesky “it depends” situations where the specifics of your lifestyle and financial means really come into play.

For most buyers, especially those who are risk-averse, interest-only loans probably are not the best option.

These loans are rare for a reason — they’re risky for the lender, yes, but they’re risky for the buyer, too. For many of us, it’s difficult to accurately predict where we’ll be financially in 5 or 10 years, and it’s equally difficult to predict future interest rates and real estate market conditions. Even if your interest-only loan terms allow for eventual refinancing, there’s no guarantee that a new mortgage will be as favorable as you may have hoped.

How do I know if an interest-only mortgage is right for me?

There are a few criteria you can examine to help determine if pursuing an interest-only home loan is a good idea for you:

How’s your financial situation?

Speaking broadly, interest-only loans are mostly for high-earning individuals who want to free up cash for investments. Ask yourself these preliminary questions before reaching out to an interest-only mortgage lender:

• Do you have strong credit to qualify for this type of loan?
• Do you have a stable (and preferably higher-than-average) income?
• Do you have a cushion of cash reserves or other assets?

How long are you planning to live in the home?

Not everyone buys a house with “forever” in mind. If you know you’re only going to stick around for a few years, an interest-only mortgage can be a great tool for keeping payments as low as possible on a property you have no intention of owning for the next 30 years.

What are your other financial priorities?

Since only having to pay the interest frees up hundreds of dollars each month, this type of home loan can be very convenient if you’re in the midst of a financial transition.

Maybe you’re saving for a child’s college education or fixing up a second home — whatever the case, if you need to keep some cash at the ready, paying as little as possible on your primary mortgage can be a great way to achieve this flexibility.

Who should avoid interest-only loans?

While interest-only loans can be beneficial in specific situations, they aren’t ideal for every borrower. You may want to avoid an interest-only loan if you fall into any of these categories:

1. Borrowers with Unstable Income: If your income is inconsistent or not expected to grow, the higher payments after the interest-only period could become unaffordable.

2. First-Time Buyers with Limited Financial Experience: If you’re new to homeownership, the complexity of an interest-only loan and its long-term financial risks may make it a less secure choice.

3. Long-Term Homeowners: If you plan to stay in your home for a long time, an interest-only loan may not be the best option since you won’t build equity during the interest-only period.

4. Borrowers in Volatile Housing Markets: In areas where home prices may decline, an interest-only loan increases the risk of owing more than the property’s market value, known as being “underwater” on your loan.

How can I find an interest-only home loan?

If you’ve ticked all the boxes and you’re feeling like an interest-only mortgage is actually right for you, now begins the quest of tracking one down.

Your best bet? Start with someone you know.

“The drawback of these loans is that they’re hard to find,” Helali reminds us again. “And in the banks that do offer them, typically they’re going to want you to have some sort of preexisting relationship with that bank.”

If you don’t have a longstanding relationship with a bank that offers interest-only loans, you can always try networking. There’s power in referrals, so if you have a friend or colleague whose financial institution offers this type of loan, and that person is willing to make an introduction and vouch for you, this can be a way to get a foot in the door.

You can also speak with your real estate agent, who likely maintains relationships with a number of mortgage lenders — possibly including interest-only mortgage lenders — and can help point you in the right direction.

Then, of course, there’s the internet. There are countless financial platforms across the web that can offer information and perhaps even the loan itself. Just be sure to proceed with caution and carefully read through every document to ensure that you have a full understanding of the terms and conditions of the loan.

“There are no stupid questions,” says Helali. “You’re spending hundreds of thousands of dollars — or millions, in some cases — on a home, so ask! Even if you feel it’s a dumb question, who cares? Ask the question.”

Buying a House This Year?

If you are thinking of buying a house this year, you might be concerned about high mortgage rates, high prices, and inventory shortages. Working with an expert buyer’s agent will help you navigate this unusual market and win your dream home. HomeLight analyzes millions of transactions to find you the perfect agent for your needs. Connect with a top agent today to get started.

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Enjoy those interest-only payments, but don’t lose focus

If you like the idea of an interest-free home loan and you’re able to find and qualify for one — great! You’ll open yourself up to unique financial opportunities and have extra flexibility in your month-to-month budget.

Buying a home always takes planning and forethought, but thinking ahead is especially important when your mortgage payments can and will fluctuate. Proceed accordingly!

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