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Mortgage Savings Strategy: Interest-Only Mortgage

One great way to reduce your monthly house payment is to get an interest-only mortgage. They’re hard to find and limited to those with good credit, but they can save you lots of money in your monthly mortgage payments.

Here’s this mortgage savings strategy in a nutshell:

When purchasing a home see if you can get an interest-only mortgage. They will reduce your mortgage payment for a limited time. 

They can be right for you if you’re:

  • Only going to be in this house for a short period
  • Going to have a significantly higher income within the next few years
  • And you have good credit

Let’s talk about this in detail so you understand how an interest-only mortgage can work for you.

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What Is An Interest-Only Mortgage?

An interest-only mortgage is a special kind of mortgage where you only pay interest on your loan for a period of time. Once that period is over, your monthly payments increase because your principal payment amounts are added to your required monthly payments.

How Interest-Only Mortgages Work

When you have a mortgage, you are generally required to make a mortgage payment each month. That payment is made up of several key elements:

  • Principal payment – this is the amount that goes towards paying off your loan. 
  • Interest on your loan – this is the amount you have to pay the bank for the privilege of using its money. Think of it as rent on the right to use their money to pay off your loan.
  • Escrow – this goes into a savings account that is used to pay for your taxes and insurance on your home at the end of the year
  • PMI Insurance – if have less than 20% equity in your home, you generally have to pay PMI Insurance, which helps protect the bank against your defaulting (stopping payment) on your loan.

Interest-only mortgages remove the principal payment on your loan for a limited period, reducing your mortgage payments. After that time expires, your mortgage payments increase as the principal payments are added to your required monthly payment amounts.

How Long Does An Interest-Only Mortgage Only Charge Interest?

That depends on your specific loan. Some offer interest-only payments for as long as 10 years but you’re more likely to find them for only 3-5 years. Be aware that you’ll pay higher interest rates for longer periods of making interest-only payments. Also, be sure to shop around to find the best deal – because these loans aren’t as readily available as traditional mortgages, banks don’t work as hard to make sure their rates are competitive.

Required Interest Rates For Interest-Only Loans

Interest-only loans are riskier for lenders than a normal mortgage because people are more likely to default on an interest-only loan than on a traditional one. Any time risks increase, mortgage lenders increase the interest rate for that loan.

As a result, the interest rate on an interest-only mortgage is usually about 1/3rd higher than on a regular mortgage, though this amount could decrease as lenders strive to offer affordable loans as interest rates increase.

So why, if the interest rate is higher, do I call this a mortgage savings strategy?

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It’s simple. The amount of money you’ll save in not having to make a principal payment each month is oftentimes more than the additional cost of the higher interest rate. So, until your principal payments kick in, this is a mortgage-saving strategy.

The biggest challenges of an interest-only mortgage are:

  • Making the higher payment once the principal payment is added to your required monthly payment amount
  • Finding one of these loans for which you can qualify

Why Is It Hard To Find Interest-Only Mortgages?

This type of mortgage was one of the causes of the 2008 housing crash. For about 2 decades prior to 2008, a set of policies and mortgage-related products created an environment of “easy money” that resulted in a large percentage of home loans being given to people who really shouldn’t have qualified for a mortgage due to their income or credit history.

In many cases, it was only a matter of time until something would happen (job loss, interest rate increase, sickness, etc.) that would make it difficult or impossible for them to make their mortgage payment and they would default on their loan.

One of those easy-money policies was interest-only mortgages. From the 1990s through the early 2000s, interest-only mortgages were available to allow real estate investors to have more cash available to purchase more properties. Unfortunately, many of those investors used these mortgages too heavily, and at the same time, mortgage lenders began offering them to normal homeowners.

These loans were affordable, until the required increase of the mortgage payment to include the principal on the loan happened, and all of the sudden, thousands of people were no longer able to pay their mortgages.

Once the dust cleared from the housing crash, policymakers created a series of new laws (the Dodd-Frank act,) rules, and regulations to try to prevent future crashes. Interest-only mortgages were one of the victims of those changes. As a result

  • Fewer lenders offer interest-only mortgages.
  • Those that do require higher credit scores, higher down payment amounts, and proof that you will be able to afford the payment when it increases to include principal payments in the future.

But that does not mean they aren’t available. In fact, in a higher interest-rate environment, it is likely they will be even easier to find. So, if you feel an interest-only loan is right for you, keep looking around until you find one that fits your needs.

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When Might An Interest-only Loan Be Right For You?

Despite the difficulty in finding them, interest-only loans are right for certain people in certain circumstances, including:

  • You are sure you will only be in this home for a short time (less than the time before the principal payment kicks in.) 
  • You are confident that inflation will cause your home price to rise, so you can sell your home for more than you paid for it. If that’s not true, and your home decreases in value, you will have to pay a significant amount of money to the bank when you sell to make up the difference.
    (Example: if you took out an interest-only loan for $350,000 and your house ends up selling for $320,000, you will owe the bank at least $30,000 on closing because your principal owed will still be $350,000. That’s not good!)
  • You can afford the higher mortgage payment that will result when your required monthly payment increases.
  • You’ve got good credit (most require a credit score of 720+) and can make a significant down payment (most require a minimum 30% down payment to qualify for an interest-only loan.) Higher amounts of savings and investment may also be required to ensure you will be able to make payments if something goes wrong in your life.
  • Interest-only loans are also popular for construction loans, some home-equity loans, and for high-income people who have enough cash to be able to pay off the entire loan at any time but wish to have more money available for other investments. 

Frequently Asked Questions

What is the advantage of an interest-only loan?

The advantage of an interest-only loan is that you will have a lower mortgage payment for a while because you only have to pay for the interest on your loan (no principal payment) for a period of time designated in your contract, at which point your mortgage payment will increase to include principal payments. 

Do banks still offer interest-only mortgages?

Some do, but to qualify for them, you must meet stiffer requirements than you would have to for a traditional mortgage, including a higher credit score, a higher down payment, and higher cash reserves. You will also have to pay a higher interest rate for that loan.

What happens at the end of an interest-only mortgage?

Most modern interest-only mortgages have a set time during which the principal is not charged. At the end of that period, your required monthly mortgage rate will increase as your principal payment is added to your mortgage payment amount. 

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What are the risks of an interest-only mortgage?

The biggest risk for an interest-only mortgage is that you won’t be able to pay your monthly minimum mortgage payments when they increase because principal payments are added to your required payment amounts. Because of this, mortgage lenders usually charge a higher interest rate for interest-only mortgages and make it harder to qualify for these types of loans with higher credit score requirements, down payments, and cash reserve requirements.

Have Questions About Adjustable Rates Or Other Mortgage Issues?

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About the Author

Scott Schang

A 20+ year veteran of the Mortgage and Real Estate industry, I am passionate about educating and empowering consumers. I have been writing about consumer protection issues and making sense of complicated real estate and mortgage topics on this website since 2007

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