Because of this, you likely won’t have predictable, fixed monthly payments. In some cases, your rate and payments will stay the same but only during the interest-only period. At the end of the interest-only period, borrowers must start making regular principal and interest payments. The loan terms typically specify the transition, which may include higher monthly payments. If you don’t have enough saved for the down payment on a conventional mortgage, or if you can’t qualify for one due to a low credit score, an FHA loan may be a good option.
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How Do Interest-Only Loans Work?
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 a way to ballpark the cost, either, Fleming says, though you can determine the lifetime interest rate cap and the floor from your contract. This would allow you to calculate the minimum and maximum lifetime cost and know that your actual cost would fall somewhere in between. If you’re refinancing but don’t have enough home equity built up, you’re in luck. As long as the home’s value appreciates, it’s possible to buy a home with an interest-only mortgage and sell it before any principal payments are due — all while earning a profit.
How Interest-Only Mortgages Are Structured
Having low monthly payments for the first several years you own your home can be a big relief, but there are also many drawbacks and risks that come along with interest-only mortgages. Read on to learn about interest-only mortgages, how you can qualify for one and more. If you’re drawn to interest-only loans because of the low monthly payment, explore government-backed loans like one from the Federal Housing Administration (FHA). These can give you more affordable payments without the future jump that comes with an interest-only mortgage. When this interest-only period ends, your monthly payment amount will raise substantially with the inclusion of both principal and interest payments. Additionally, if the interest-only loan is also an ARM, the payment amount may also fluctuate due to the periodic interest rate changes.
Lenders will also want to look at your employment history and income trends, as well as verify your current job with your employer. This ensures you’re able to make your payments, both now and once the interest-only period expires. Your income is the biggest consideration with an interest-only mortgage. For instance, this type of mortgage could be useful if you’re confident you’ll earn more money down the road. If you know you’re going to get your annual bonus at the end of the year or you’re due for a raise soon, it could be the right fit.
- If you can’t afford the higher payments on today’s income, consider another loan.
- An interest-only mortgage may be the right home loan if you want to keep your housing costs low and are confident you’ll refinance or move before you have to pay both principal and interest costs.
- Lenders will also want to look at your employment history and income trends, as well as verify your current job with your employer.
- Morgan offers investment education, expertise and a range of tools to help you reach your goals.
Alternatives to an interest-only mortgage
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. Second, the interest payments on an interest-only mortgage for an investment property may be deducted as a business cost. This can also lower the taxable income from the rental property and assist offset rental income.
It is important to consider the long-term affordability and potential fluctuations in interest rates. An interest-only mortgage is a home loan that at first requires you to only pay interest costs — not the principal. That means your early payments won’t reduce your principal balance. Interest-only mortgages have more affordable monthly payments at first. If you’ve served in the military, you may qualify for a VA loan backed by the U.S.
Last, borrowers may have greater cash flow available for other objectives such as investing or establishing a business, by making smaller initial monthly payments during the interest-only term. Due to the additional liquidity, there may be prospects for tax benefits related to those operations. For example, investors may use cash savings to invest in equities until principal payments are required; this may result in higher-than-usual capital gains or losses. If an interest-only loan isn’t a good fit, one alternative is a hybrid adjustable-rate mortgage like a 5/1 ARM loan.
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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. Most interest-only mortgages require only the interest payments for a specified time period—typically five, seven, or 10 years. After that, the loan converts to a standard schedule—a fully-amortized basis, in lender lingo—and the borrower’s payments will workers compensation coverage through a peo increase to include both interest and a portion of the principal. Monthly payments for interest-only loans tend to be lower than payments for standard loans. That’s because standard loans typically include interest costs plus some portion of the loan balance.
Usually, interest-only loans are structured as a particular type of adjustable-rate mortgage (ARM), known as an interest-only ARM. You pay just the interest, at a fixed rate, for a certain number of years, known as the introductory period. After the introductory period ends, the borrower starts repaying both principal and interest, and the interest rate will start to vary. For example, if you take out a “7/1 ARM”, it means your introductory period of interest-only payments lasts seven years, and then your interest rate will adjust once a year. Interest-only mortgages carry risks, as borrowers do not build equity during the initial period and face higher payments when transitioning to principal and interest payments.
Some of our turbotax deluxe 2020 desktop tax software, federal and state returns + federal e experts have even used these lenders themselves to cut their costs. Lenders also use the full loan payment amount to calculate your debt-to-income ratio (how much debt you have compared to how much money you earn). That includes principal and interest, even though you’re only paying interest to start.
It is possible to refinance a traditional mortgage to an interest-only loan, and borrowers might consider this option as a way to free up money to put toward short-term investments or an unexpected expense. You would meet the same scrutiny and requirements as you would if applying for a first-time interest-only loan. If you’re looking for lower monthly payments or a short-term living arrangement, this could be the right option for you.
If you want homeownership to be a significant part of your financial portfolio, an interest-only mortgage isn’t a good tool to help you get there. That freed-up cash flow could make for other investment opportunities, too. You may be able to invest more money in the stock market, your 401(k), or even other real estate purchases that can help you build your wealth.