With most mortgage loans, the arrangement is pretty simple: You borrow X amount of money from a lender for a specific mortgage term and then pay it back -- plus interest -- every month you own the home.
Interest only loans, however, function a bit differently. On these loans, you’ll instead pay the lender for only the interest costs of your mortgage for a set period -- usually between three and 10 years. Once that period expires, you’ll start making payments toward both the principal and interest.
Obviously, with interest rates at record lows, this probably sounds like quite the deal. But interest only loans aren’t without drawbacks. Let’s take a look at these mortgages and what borrower they might be right for.
How do interest only mortgage loans work?
Interest only mortgages have two distinct periods: The interest only period and the amortized period. In the interest only period of the loan, you’ll still make a monthly payment, but only enough to cover the interest accrued on the loan for that month. On a 30-year, $300,000 loan at a 3% rate, for example, that’d mean about $750 per month.
Once the interest only period runs out, you’ll enter the amortized period, which is when you’ll start paying toward the loan’s principal balance -- in addition to the interest costs.
This causes a pretty big jump in payments for a few reasons: First, you’re adding a principal payment to the equation. On top of this, though, you’ve also shortened your repayment term. If you had a 30-year loan but made interest only payments for the first seven years, your loan balance is now spread across 23 years (276 months) rather than 30 (360 months). This takes your monthly mortgage payment up considerably -- in the case above, from $750 to over $1,500.
Another issue that can make that amortized period more challenging is that most interest only loans come with adjustable rates. So, on top of adding principal payments to your monthly bill, your interest rate could increase, too. This would mean an even more expensive monthly payment than you might be planning for.
Pros and cons of interest only mortgages
As with any type of loan product, there are both advantages and disadvantages to using an interest only mortgage. On the upside, interest only mortgages can come with very low monthly payments -- at least for the first few years of the mortgage term. This can make it easier to afford a home and may allow you to purchase one sooner than you think.
It’s also beneficial if your income is low now but you expect it to grow in the future -- before those larger principal payments start coming due.
That’s about where the pros end, though. Interest only loans come with some definite drawbacks, namely the much higher monthly mortgage payments they require down the line. Let’s say you got a $200,000 mortgage at a 3% rate. Your interest only payment would be just $500 per month, but once that period expired (say, after seven years)? You’d owe $1,004 per month. If your loan had an adjustable rate, it’d jump even more.
That’s another big downside: Most interest only loans come with adjustable rates. This means your interest rate can increase over time, taking your monthly payment up with it.
Finally, interest only loans also make it difficult to build equity in your home -- at least until you start paying down the principal. This could be a problem should you need to sell your home or do a cash-out refinance. With little equity, you might not make much profit off your home or, in some cases, may even owe more than it’s worth.