When planning for homeownership, it's important to understand your mortgage options. A mortgage is a loan secured by real estate property, typically a home, that you pay off over a specific period. While there are several types of mortgages, one type that stands out due to its unique features is the interest-only (IO) mortgage.

What Is an Interest-Only Mortgage?

An interest-only mortgage is a specific type of home loan whereby the borrower is only obligated to pay the interest on the principal balance for a set term. The structure of these loans can be divided into two distinct periods: the interest-only period and the principal repayment period.

The interest-only period is the initial phase that lasts for a set period, usually between five to 10 years. During this time, your monthly mortgage payments go towards the interest on your loan. This makes the initial payments lower compared to other mortgage types, giving homeowners more financial flexibility. However, because you’re only paying for the interest, you’re not building any home equity (unless your property’s value increases).

Once the interest-only phase ends, you enter the principal repayment period, and the loan turns into a more traditional mortgage. Monthly payments increase, but they now go towards the principal and interest, allowing you to build equity. The principal repayment period continues for the remainder of your loan term, so if you have a 30-year mortgage and your interest-only period lasts seven years, the principal repayment period covers 23.

Types of Interest-Only Mortgages

Interest-only mortgages are available with a variety of interest rate types. the table below breaks down each one.

Type
Description

Adjustable-Rate

These loans offer an interest-only period, but the rate may change during this time. The interest rate is typically tied to a specific financial index and can increase or decrease, depending on market conditions. While this type can offer lower initial rates, it also carries the risk of higher future payments if interest rates rise.

Fixed-Rate

Although less common, you can also have interest-only mortgages with fixed rates. As its name implies, the interest rate remains fixed during the interest-only period, resulting in predictable monthly payments. The rate usually stays constant throughout the loan's lifespan, offering stability even when the principal payments begin.

Hybrid

This is a blend of fixed and adjustable-rate features, like a 5/6 interest-only ARM. It has a fixed rate for the first five years, during which you only pay the interest. After that, the rate becomes variable for the rest of the loan term, and you begin to pay both the principal and the interest.

How Do Interest-Only Mortgages Work?

The best way to understand how this type of mortgage works is by looking at a real-life example. Here, we’ll use Corrine, a freelance graphic designer who bought a home for $300,000. She secured an interest-only mortgage with a 5% annual interest rate. Her interest-only period is set to last for the first five years of her 30-year loan.

During the interest-only period, Corrine’s total interest per year is $15,000. You get that by multiplying her loan amount ($300,000) by her annual interest rate (5%). Divide that by 12 to get her monthly payment, which is $1,250.

After five years, Corrine’s interest-only period ends, and her monthly payments will begin covering the principal and the remaining interest. From that point forward, she must pay $1,754 each month for the remainder of her loan.

Benefits and Drawbacks of Interest-Only Mortgages

Mortgages are long-term commitments, and they don’t just affect your monthly budget — they can also influence your financial planning, investment strategies and overall lifestyle. An interest-only mortgage may seem attractive because of lower initial payments, but it also comes with potential risks and challenges. Considering both aspects gives you a more comprehensive understanding, and you’ll be more likely to make an informed decision that aligns with your financial goals and circumstances.

Advantages of Interest-Only Mortgages

  • Lower Initial Payments. During the interest-only period, borrowers only pay the interest portion of the loan. This arrangement results in lower initial payments compared to conventional mortgages, where principal and interest are paid simultaneously from the beginning.
  • More Cash Flow Flexibility. Since your initial payments are lower, you can free up funds for other financial needs or investments. This flexibility can be particularly beneficial for borrowers with variable income or those expecting an income increase in the future.
  • Potential Tax Deductibility. Depending on your individual tax situation and location, the interest paid on your mortgage may be tax-deductible, which could reduce your taxable income and result in tax savings. That said, it’s best to consult a tax professional to see if you’re eligible.
  • Opportunity for Investment or Savings. The lower initial payments can free up cash for other purposes, such as investing in higher-return ventures or building an emergency fund. However, it's important to carefully evaluate the potential returns against the risk of larger mortgage payments in the future.

Potential Drawbacks and Considerations

  • No (or Low) Equity Growth. During the interest-only period, you are not reducing your loan's principal amount, meaning you're not building any home equity unless the property's market value increases. A lack of equity can limit your financial flexibility in the future.
  • Higher Total Interest Payments. Over the lifespan of the loan, you could end up paying more in interest with an interest-only mortgage compared to other types of loans. Because of delayed principal payments, the period when interest continues accruing is extended.
  • Possible Payment Shock. After the interest-only period ends, the mortgage payments increase significantly since you’ll begin to pay off the principal. This sudden increase is known as payment shock and can strain your finances if you don’t plan for it properly.
  • Qualification and Eligibility Requirements. Lenders consider interest-only mortgages riskier than other mortgage types, so they may require a higher credit score, lower debt-to-income ratio and larger down payments.

Who Benefits Best From an Interest-Only Mortgage?

Interest-only mortgages are not a one-size-fits-all solution, but they can offer unique advantages to some borrower profiles more than others. By understanding these scenarios, you can better decide if this type of mortgage might be a good fit for your financial situation.

Pauline, A Real Estate Investor

Let's imagine Pauline, a real estate investor. Pauline buys properties, improves them and sells them for a profit. An interest-only mortgage can be a smart choice because she only plans to hold the properties for a short time. During her ownership, she will make lower interest-only payments, keeping her costs down until she sells the property for a higher price.

James, a High-Income Borrower

James is a successful surgeon and has a high income but also has considerable monthly expenses. These include student loan payments and private school fees for his children. An interest-only mortgage could be beneficial for James as it offers lower initial payments, freeing up cash for his immediate financial obligations. As his expenses decrease over time, he can start making principal payments or even pay off the mortgage in a lump sum.

Linda, a Homeowners with Irregular Income

Picture Linda, a freelance graphic designer. Linda's income fluctuates throughout the year, with some months bringing in more income than others. An interest-only mortgage could provide Linda with the flexibility she needs. In months when her income is high, she can choose to make additional payments towards the principal. In leaner months, she can stick to the lower interest-only payments.

Alex and Emma, Short-Term Homeowners

Alex and Emma are a young couple planning to live in a city for only a few years for work. They want to buy a house instead of renting, knowing they'll likely sell it within five years. With an interest-only mortgage, they can take advantage of the lower payments during their stay and sell the house before the repayment period starts.

Remember, these scenarios are examples and might not reflect every situation. It's best to consider your personal financial circumstances and consult with a financial advisor before making a decision.

Risks and Mitigation Strategies

Interest-only mortgages also come with several risks, such as interest rate increases, fluctuation of property value and prepayment penalties. These situations could affect your financial future significantly, so it’s key to explore them before deciding if an interest-only mortgage is the best choice for you.

Risk
Description
Mitigation Strategy

Interest Rate Risks

Interest rates can be a bit like a roller coaster, sometimes going up, sometimes down. If they go up, your monthly payments will follow suit. This can be a shock, especially if you’re on a tight budget.

Keep a close eye on market conditions and plan for possible rate changes. If rates increase significantly, refinancing your mortgage to a fixed-rate loan may be an option. This gives you a steady, predictable ride with stable payments.

Property Value Fluctuations

The housing market can be unpredictable, making your property value increase or decrease over time. If it goes down and you need to sell, you could end up in a tough spot, potentially owing more than your home is worth.

Conduct thorough research and understand the housing market in your area before purchasing a home. You can also consider diversifying your investments — putting funds in other assets besides your home to balance your financial portfolio.

Prepayment Penalties

Some lenders impose penalties if you pay off your interest-only mortgage early.

Understand the prepayment terms in your mortgage agreement, and if possible, negotiate for better prepayment options. This gives you the freedom to make extra payments or refinance without being hit with penalties.

While interest-only mortgages present certain risks, these can be managed effectively with foresight, research and strategic planning.

Qualifying for an Interest-Only Mortgage

Before you secure an interest-only mortgage, it's best to understand lenders’ requirements and eligibility criteria to help you assess your readiness to apply and increase your chances of approval.

  • Credit Score and History Requirements. Your credit score is a numerical representation of your creditworthiness — the higher it is, the better you’re able to manage your debt. Scores above 700 are generally considered good, while those above 800 are deemed excellent. If your score isn't where you want it to be, don't panic. You can take steps to improve your credit score, like paying off debts on time and maintaining a low balance on your credit cards.
  • Debt-to-Income Ratio Considerations. Debt-to-Income (DTI) ratio measures your monthly debt payments relative to your gross monthly income. Lenders use it to assess your ability to manage monthly payments and repay loans. Generally, a DTI ratio of 43% or lower is seen as good.
  • Down Payment and Loan-to-Value Ratio: The down payment is how much you pay upfront when you purchase your home, while the loan-to-value (LTV) ratio is the amount of the loan compared to the value of the property. Lenders may require a larger down payment for interest-only mortgages to offset their risk. The more you pay upfront, the less you owe, resulting in a lower LTV ratio, which makes you less risky for lenders.
  • Documentation and Verification Process. Be prepared to show paperwork that verifies your income, employment and assets. You can use tax returns, pay stubs, bank statements and or other items that show lenders you have the means to repay your loan.

Alternatives to Interest-Only Mortgages

One size does not fit all — and that is true for mortgages, too. There are several other mortgage options you can explore if an interest-only mortgage doesn't align with your financial goals or lifestyle. Each alternative carries its unique set of features and benefits, offering different payment structures and levels of risk.

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    Traditional Fixed-Rate Mortgages

    This is the most common type of mortgage. It features a fixed interest rate that remains the same for the life of the loan. It allows your monthly mortgage payments to remain constant, providing stability and predictability in your budgeting.

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    Adjustable-Rate Mortgages (ARMs)

    Unlike fixed-rate mortgages, ARMs have interest rates that adjust over time depending on market conditions. They typically start with a lower interest rate than fixed-rate mortgages but can increase or decrease after the initial fixed-rate period ends. ARMs can be a viable option for those willing to take on some risk in exchange for lower initial payments.

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    Balloon Mortgages

    Balloon mortgages are short-term home loans that feature small, regular payments for a set number of years, followed by a large payment of the remaining balance (hence the term ‘balloon’). This option can be beneficial if you plan on selling your home or refinancing your mortgage before the balloon payment is due.

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    Refinancing

    If you already have a mortgage but find the payments challenging, refinancing might be an excellent option. The same applies if you want to take advantage of lower interest rates. Refinancing replaces your existing loan with a new one that better fits your current financial circumstances.

There are numerous paths to home financing — whether an interest-only mortgage or another option is right for you depends on your financial goals, lifestyle and risk tolerance. Exploring all alternatives can ensure you make an informed decision that suits your individual needs.

Frequently Asked Questions (FAQs)

To help you make the most informed financial decisions possible, we answered several frequently asked questions about interest-only mortgages.

About Christopher Boston


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Christopher Boston is a Senior Manager of Content Strategy and SEO at MoneyGeek. For over half a decade, they have crafted hundreds of articles spanning the higher education, mortgage and personal loan industries. Christopher is passionate about using their skills and experience to create quality content that helps people save and spend their earnings efficiently.