An interest-only mortgage is when you are not required to pay back the principal balance of a loan during the set term. Instead, monthly payments initially target only the acquired interest on the loan. Interest-only loans may give the borrower more financial freedom to operate in the market in a more advantageous manner.
What is an Interest-Only Loan?
There are two main types of loans – an amortized loan and an interest-only loan. An amortized loan is where you pay back the interest and part of the principal balance each month. An interest-only loan is where you are only required to pay back the interest of the loan for the first several years of the loan term.
How do Interest-Only Loans Work?
The actual payment timeline on interest-only loans varies between lenders. However, the interest-only repayment can be up to ten years. This means that for the first ten years of the loan, you will only be required to pay the interest portion of the loan. After ten years have passed, the payments will increase significantly. You will have to either pay back the principal in a lump sum or make subsequent payments on both interest and principal amounts.
Qualifications for an Interest-Only Loan
Interest-only mortgages can be a risk for the lender. For that reason, an interest-only loan is harder to qualify for. The exact qualifications will differ between lenders, but the list below contains the general guidelines:
- Large down payment. Because of the high risk to the lender, the lender will require a higher down payment for an interest-only loan than an amortized loan. Some lenders may ask for up to 50% of the loan as a downpayment.
- Low debt-to-income ratio. Lenders will look for a low debt-to-income ratio to show the ability to pay back the loan.
- Good credit score. Lenders will look for a borrower with a good to excellent credit score. The exact score may differ between lenders, depending on the purpose of the loan and an individual’s financial history. However, many lenders prefer borrowers with a 700+ FICO score to minimize the risk of non-repayment.
- Evidence of sufficient earnings. The lender may ask to see savings and business accounts for an additional guarantee.
- A thorough mortgage repayment plan. The lender may ask to see how you plan to pay back the loan. Paying back an interest-only loan requires more foresight and financial planning from the borrower, so having a repayment plan prepared reflects positively on the borrower.
The key to qualifying for an interest-only mortgage is to have sufficient funds and a soundproof plan for your repayments. The lender will want to see that you are financially prepared for the loan.
What are the Advantages of an Interest-Only Mortgage?
Choosing an interest-only mortgage can be advantageous for many investors including those that want to:
- Increase cash flow. An interest-only mortgage is a great option for investors looking to maintain a higher cash flow when interest rates are going up and their cash flow margins are thinning. An interest-only loan requires smaller initial payments, giving the investor more cash flow for other investments.
- Qualify for a larger property. While payments will remain low at the beginning, they will increase significantly later on. This allows you to purchase a larger property if you foresee a significant income increase or rise in revenue in the future.
- Pay off the loan faster. Most interest-only mortgages do not limit the additional payments you can make on the loan. That means you can pay back the principal of the loan on your own schedule.
Interest-only mortgages are useful for short-term loans, such as bridge loans or fix-and-flip loans. An interest-only mortgage can be useful if you are planning to sell the property within the first few years of purchasing. You can pay off the loan by selling the property and keeping payments low while you hold it.
What are the Disadvantages of an Interest-Only Mortgage?
Some disadvantages associated with interest-only mortgages include;
- Higher interest rates. While overall monthly payments are lower without having to pay down the principal, interest rates are generally higher with an interest-only mortgage.
- Temporarily low payments. Initially, the monthly payments are significantly lower with an interest-only mortgage. However, once the interest-only term expires, the total monthly payments will increase drastically. This can be a shock to an unprepared borrower.
- No increase in equity. When you take out an amortized loan, you will make payments against the principal portion of the mortgage, gaining a little bit of equity in your propety each month. If you decide to sell, you will receive more cash out. And if the market turns and your property value decreases, you will still maintain some equity. However, with an interest-only loan, your equity will stay constant as long as you are only making payments on the interest. You will be less protected in a down-turn, and you will get less cash out upon sale.
With an interest-only mortgage, it is important to be prepared for the increase in payments once the interest-only term expires.
When Should you Use an Interest-Only Mortgage?
If you are looking to keep monthly repayments low in the short run, then an interest-only mortgage is a good option.
This makes it appealing to investors who plan to hold property only in the short term. It also makes it a viable option for any investor looking to temporarily increase monthly cash flow when the market interest rates are high.
How to Calculate Interest-Only Payments
Interest-only mortgages make for significantly lower monthly payments. The calculated payments will depend on the given interest rate and whether it is an adjustable-rate or a fixed-rate. The example below is looking at a fixed interest rate mortgage.
Example of Payments on an Interest-Only Mortgage
On a mortgage of $500,000 with a 4% interest rate, payable over 25 years, you will pay approximately $1,666 a month. With an amortized loan, the total payment would be nearly double that amount per month.
The difference between the two is with an interest-only loan you are only paying off the accrued interest each month. That means at the end of the 25-year term, you will still owe the initial $500,000 loan.
We should note that most interest-only mortgages have a set term for the interest-only payments. That means if the loan term is 25 years, the interest-only payments may be for the first 5-10 years of the loan.
How to Pay off an Interest-Only Loan
When planning for re-payment of an interest-only loan, there are several options. The most common are;
- Refinance the loan at the end of the term to include principal payments.
- Sell the property to pay off the loan.
- Make a lump-sum payment with saved earnings.
Paying off an interest-only loan can be relatively simple if the investor is planning on selling the property before the end of the loan term. By doing so, the investor can pay off the loan balance with the profits from selling the property.
Switching to Interest-Only Payments
Some lenders allow a borrower to temporarily switch to interest-only payments. This would be advisable when investors are looking to increase expendable cash flow for further investments, or if an individual is struggling to meet payments (but has a favorable future regarding finances).
The lender will look at all the same requirements noted above for an interest-only mortgage. They will look into your finances, repayment plan, and FICO scores before allowing you to switch.
Where to Get an Interest-Only Loan
Most lenders, financial institutions, and banks will offer an interest-only loan if all requirements are met.
Interest-Only Mortgage Alternatives
The only alternative to an interest-only mortgage is a repayment mortgage. In a repayment mortgage, your monthly payments include paying off both interest and principal on the property.
In a repayment mortgage, your monthly payments will often be placed on an amortization schedule. Here, they split up your monthly payments into equal amounts to pay off both interest and principal.
Fixed-Rate Vs. Adjustable-Rate Interest-Only Mortgages
A fixed-rate mortgage has a set interest rate. The amount of interest you pay will never fluctuate. Conversely, an adjustable-rate mortgage will shift according to specific loan terms.
Both options have advantages and disadvantages associated with them. It’s important to have an understanding of each option to ensure the best possible outcome for both the lender and borrower.
Pros and Cons of Fixed-Rate Interest-Only Mortgages
A fixed-rate mortgage (FRM) offers borrowers the ability to know exactly what the repayment plan requires from start to finish.
Although FRM loans take the guesswork out of the equation, many borrowers still prefer an adjustable-rate option.
Pros and Cons of Adjustable-Rate Interest-Only Mortgages
An adjustable-rate mortgage (ARM) is the most popular form of an interest-only mortgage among lenders and investors.
Most interest-only mortgages will be an ARM. These provide more security and stability to the lender.
Everything you Need to Know About an Interest-Only Mortgage
While interest-only mortgages carry unique risks, , they can be a vital tool for an investor seeking to increase monthly cash flow.
When managed correctly, an interest-only mortgage can give the borrower more monthly investment funds for additional projects. This is a good option for investors who plan to sell the property shortly after purchasing, or for an investor foreseeing a significant income increase.
Interest-only mortgages do come with their own pitfalls. This type of mortgage can be risky for the ill-prepared borrower, so it is important to maintain a solid foundation and a good grasp of your personal financial situation.