First, if you take out an interest-only mortgage, you will not gain any equity in your home (beyond the equity of your down payment) until you begin principal payments. The days of cheap money are gone with the Fed undertaking the most aggressive rate hike campaign in four decades to battle inflation. Most people turn to credit cards when they’re cash-strapped, but financial advisers say they should be a last resort and that consumers should consider other options first. In exchange for the lender credit, you pay a higher interest rate than what you would have received with the same lender, for the same kind of loan, without lender credits.

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• So, the monthly payment will balloon to a significantly higher amount, which can be difficult for the borrower to pay.
• Choosing the right credit counseling agency, like researching the right mortgage for your situation, is a good way to limit risk and grow financial stability.
• That’s especially true for financially sophisticated borrowers who have opportunities to put their would-be principal payments to better use.
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There are much less risky loans available than interest-only mortgages but that doesn’t mean taking out those loans requires less planning. Interest-only loans have several benefits, including making monthly mortgage payments initially more affordable. On the other hand, there are some drawbacks—like higher payments once the interest-only period concludes—that borrowers will need to consider as well. Use this interest-only calculator to see how much one of these loans might cost you. An interest-only mortgage requires payments just of the interest — the cost of borrowing money — during the first years of the loan.

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. Interest-only loans have been harder to come by since the housing crisis of the mid-2000s.. Fewer lenders offer them, and banks have set stricter requirements to qualify. It’s important to distinguish between actual benefits and the temptation of a lower payment. Interest-only loans work well when you use them as part of a sound financial strategy, but they can cause you long-term financial trouble if you use interest-only payments to buy more than you can afford.

How Interest-Only Mortgages Work: Pros and Cons

It could also be a good option if you don’t mind trading higher payments later for lower payments when you take out a home loan. However, you must be a well-qualified borrower to get an interest-only loan. Requirements vary, but even the best mortgage lenders typically require good or excellent credit. Most also require a larger down payment than you’d need for a traditional mortgage. Interest-only mortgages might also appeal to borrowers who trust the home they purchase will appreciate significantly in the immediate future.

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That only works if the borrower plans to make the higher payments after the introductory period. For example, some increase their income before the intro period is over. The remaining borrowers refinance to a new interest-only loan, but that doesn’t work if interest rates have risen. Interest-only mortgages reduce the required monthly payment for a mortgage borrower by excluding the principal portion from a payment. Homebuyers have the advantage of increased cash flow and greater support for managing monthly expenses.

Since it initially doesn’t require you to make payments toward the principal, your monthly payment will be less. Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest-only loan with an endowment policy, the combination being known as an endowment mortgage.

Typical uses for an interest-only mortgage

Interest-only mortgages don’t qualify for government-backed programs like FHA, VA or USDA loans. And there are a few other key differences between interest-only and conventional mortgages as well. In today’s market, it’s possible to buy a home with an interest-only mortgage, sell it before any principal payments are due and earn a profit, says Mayer Dallal, managing director at non-qualified mortgage lender MBANC. “The home prices are going up, so they can take advantage of the capital appreciation that way,” he says.

Unless you are incredibly financially disciplined, you might not be able to afford these payments. Some interest-only mortgages even require that you pay off the loan in a lump sum when the introductory grace period ends. Remember 2008, the worst housing market debacle since the Great Depression? Interest-only loans were one product that allowed homebuyers to purchase property they couldn’t otherwise afford.

What is an adjustable-rate mortgage?

You can repay some of the principal at any time to help keep future payments lower. 5/1 traditional ARM–The monthly payment stays at $1,126 for 5 years but
then changes with the interest rate. In the example, the monthly payment would be $1,344 if interest rates
rose 2% in year 6.

An interest-only mortgage is smart for the forward-thinking borrower who has a sound plan to make future payments. Otherwise, it makes more sense to pursue a traditional mortgage, avoiding the temptation to bite off more than your wallet can chew. Credit cards are OK for small purchases to help manage your monthly cash flow, and if you pay off all or most of the balance on time.

In fact, these interest-only loans are part of what really caused the subprime mortgage crisis. Interest-only loans aren’t necessarily bad, but they’re often used for the wrong reasons. If you have a sound strategy for using the extra money (and a plan for getting rid of the debt), they can work well.

You will have lower monthly payments only during the first few years. You will have larger payments
later–and you will need to have the income to cover those larger payments. 5/1 interest-only ARM–The monthly payment stays at $960 for 5 years but
increases to $1,204 in year 6.

We maintain a firewall between our advertisers and our editorial team. Our editorial team does not receive direct compensation from our advertisers. Most house flipping loans are interest-only to maximize the money available for making improvements. With an interest-only loan, your loan payments are only enough to cover the loan’s interest. Catch up on CNBC Select’s in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date. Read the terms of an interest-only loan closely and make a sound plan for the duration of the loan.

The principal is repaid either in a lump sum at a specified date, or in subsequent payments. As mentioned above, buyers might plan to sell the property before the interest-only period has ended, with the idea that it will appreciate so they can pay off the loan and still have money for a new home. The risk in this strategy is that the house may not increase in value as expected. One of the customer deposit definition major risks in an interest-only loan is that the buyer may not be able to afford the higher payments when they take effect. To avoid this issue, you can provide a larger down payment and/or pay additional principal whenever possible to lower the balance before re-amortization occurs. Payments will then increase to those of a typical, amortized loan, covering both principal and interest.