Interest Only Mortgage: Definition, Types, Pros and Cons


Delve into the world of interest-only mortgages with this comprehensive guide. Learn about the intricacies of interest-only loans, their advantages, drawbacks, and gain insights from real-world scenarios. Explore how interest-only mortgages can impact your financial planning and homeownership journey.

Interest only mortgage: exploring the features, pros, and cons

In the realm of mortgages, the interest-only option presents a unique approach that has garnered attention for its distinct features and implications. This article provides an in-depth exploration of interest-only mortgages, including their mechanics, benefits, drawbacks, and real-life applications.

Understanding interest only mortgages

An interest-only mortgage is a type of home loan where the borrower pays only the interest for a specific period, typically ranging from 5 to 10 years. During this period, the monthly payments solely cover the interest accrued on the loan amount, excluding any principal repayment.

How interest-only mortgages work

The operational framework of an interest-only mortgage revolves around two main phases:

1. Interest-only phase

During this initial period, borrowers make monthly payments that exclusively address the interest accrued on the loan. The principal amount remains unchanged, which often results in lower monthly payments compared to a traditional mortgage.

2. Principal and interest phase

Following the interest-only phase, borrowers transition into paying both interest and principal. Monthly payments increase to ensure that the entire loan amount is repaid over the remaining loan term.

Examples of interest-only mortgages

  1. Young Homebuyer Strategy: A young professional who expects their income to rise over the coming years might opt for an interest-only mortgage. This allows them to have lower initial monthly payments while planning to switch to traditional payments as their income grows.
  2. Property Investment: Investors purchasing properties to rent may use interest-only mortgages to minimize monthly costs and maximize potential rental income. They can later sell the property to cover the principal or refinance.
  3. Short-Term Homeownership: Individuals planning to sell their home within a few years might opt for an interest-only mortgage to keep initial costs low and potentially sell the property before the principal and interest payments begin.

Here is a list of the advantages and disadvantages to consider.

  • Lower Initial Payments: Monthly payments during the interest-only phase are typically lower.
  • Investment Flexibility: Investors can allocate funds elsewhere during the interest-only period.
  • Short-Term Strategy: Useful for short-term homeownership or planned property sales.
  • Principal Repayment Delay: The principal balance remains unchanged during the interest-only phase.
  • Higher Long-Term Costs: Payments increase after transitioning to the principal and interest phase.
  • Risk of Property Value Decline: If property values drop, borrowers may owe more than the property is worth.

Frequently asked questions

Can I Make Extra Payments During the Interest-Only Phase?

Yes, some lenders allow borrowers to make additional payments toward the principal during the interest-only phase. This can help reduce the principal balance and the overall interest paid.

What Happens If I Can’t Afford the Increased Payments?

If you’re unable to afford the higher payments after transitioning to the principal and interest phase, you should discuss options with your lender. Refinancing, extending the interest-only period, or selling the property might be considered.

Are interest-only mortgages suitable for everyone?

No, interest-only mortgages are not suitable for everyone. They are typically better suited for financially responsible borrowers who understand the risks and have a financial plan in place to handle the increased payments when the interest-only period expires.

What happens when the interest-only period ends?

When the interest-only period ends, borrowers are required to start making payments that include both principal and interest. These payments will be significantly higher than the interest-only payments.

Can I pay down the principal during the interest-only period?

In most cases, borrowers have the option to make additional payments towards the principal during the interest-only period. Doing so can reduce the total interest paid and the outstanding balance when the interest-only period ends.

Key takeaways

  • Interest-only mortgages involve making interest payments for an initial period, followed by principal and interest payments.
  • Examples of interest-only mortgages include young homebuyers, property investors, and short-term homeownership strategies.
  • Pros of interest-only mortgages include lower initial payments and investment flexibility.
  • Cons encompass delayed principal repayment, higher long-term costs, and potential property value risks.
  • Consider extra payment options and potential affordability challenges when choosing an interest-only mortgage.
View Article Sources
    1. Interest-Only Mortgages – Consumer Financial Protection Bureau
    2. Understanding Interest-Only Mortgage – FDIC: Federal Deposit Insurance Corporation
    3. What Is an Interest-Only Mortgage? – Legal Information Institute, Cornell Law School
    4. Mortgage Broker: Definition, Pros & Cons – SuperMoney