Interest-Only Mortgage

When buying a house with an Interest-Only home loan (or Interest-Only mortgage), you pay only the interest owed on your loan each month when you make a mortgage payment. Mortgage companies created Interest-Only loans as an optional alternative to traditional loans where your monthly mortgage payments go towards both the interest costs of the loan and the principal loan balance, which is the amount you originally borrowed.

An Interest-Only mortgage allows you to only make interest payments for a fixed term. This term is usually between 5 to 10 years. Since each monthly payment only goes toward the interest, your loan balance does not decrease unless you make additional payments toward the principal loan amount.

During this time frame, you have the right to pay more than the interest payment if you want. However, if you opt not to pay toward the principal loan amount then the loan balance remains the same.

Interest-Only home loans were designed to offer borrowers an alternative to traditional Fixed-Rate mortgages to finance a new property. It can be added to traditional loans to offer more flexibility for borrowers who qualify. They are generally designed the same way Adjustable-Rate mortgages are, where the monthly payment will change after a set time period. This can be particularly beneficial to borrowers who are using it to buy an investment property that they intend to sell after a few years, or for buyers who expect their income to increase in the near future.

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An Interest-Only mortgage works by allowing borrowers to make lower monthly payments for a set amount of time. Once the interest-only term expires, many homeowners choose to refinance their home, pay a lump sum, or simply begin the process of paying off the original loan principal. Borrowers should prepare for considerably higher monthly payments once those payments include the principal as well as the interest costs.

Interest-Only loans are helpful to borrowers who are already financially secure or a homeowner who is using them to fund a second home. For example, if you are planning to own the house you are financing for a limited time, an Interest-Only loan could be beneficial to you. It will provide you with lower monthly payments, then, at the end of the interest only period you can refinance. You can also make money reselling the property if the value of the home has appreciated.

Interest-Only loans involve an increased risk for lenders. Due to this fact the requirements to qualify for Interest-Only loans are somewhat different from those required for a traditional loan. They are also more varied from lender to lender.

Requirements to qualify for an Interest-Only loan include:

• The ability to verify source income – this can include things like pay stubs and bank statements
• Ability to afford higher payments when the rate changes – there is a significant difference between the interest-only payments at the beginning of the loan life and the full mortgage payments at the end. Borrowers should budget and apply for the loan with the larger payments in mind.
• Ability to pay a higher down payment – generally lenders will look for a minimum 15% down payment, though this varies by both the loan program and the lender.
• Lower debt-to-income ratio
• A good credit score – lenders will generally want to see a credit score in the high 600s to mid 700s to qualify.

Generally, Interest-Only loans can be particularly useful if one of the following guidelines applies to your situation:

• You expect to sell your home or refinance it prior to the interest only period ending.
• Your personal income heavily relies on bonuses or commission checks that come infrequently during the year; so you want the flexibility of making interest-only payments during the times when your income is low and then paying more when your income increases.
• You're looking for a first-time homebuyer mortgage and you expect to earn significantly more income in the next few years.

There are several advantages that many borrowers find with an Interest-Only home loan.

These pros include:

• Lower monthly mortgage payment
• Additional cash available to pay toward higher-interest debts or for investing in other properties or stocks
• More control over cash flow allows you to use your money how you want, for personal goals like continuing education or other expenses
• The entire monthly payment during the interest only period usually qualifies as tax-deductible. Be sure to ask your tax adviser when you pay your yearly taxes.
• If it’s a short-term investment property such as a fixer-upper, interest-only payments help keep costs low, so your money is available to be leveraged in other areas.

As with any type of loan, there are potential drawbacks to be aware of.

Possible cons include:

• Mortgage rate increases in an ARM loan after the initial interest-only period has ended may cause the payment to become unaffordable. 
• Homes may not appreciate as quickly as the borrower would like.
• Some borrowers may not be able to afford to pay the principal when the time comes.
• It may be difficult to build equity in your home with interest-only mortgages unless you opt to make extra payments.
• You don't get the same amortization that you do with other loans.

There are further potential risks you should be aware of with interest-only loans. One such risk is that it is possible the home may be worth less than what is owed, or it will rapidly depreciate if housing prices fall. 

Some of the loan types that offer an interest-only option include:

• Adjustable-Rate Mortgages: A loan with an interest rate that changes. There is an initial period where the rate is fixed, after which, the interest rate adjusts according to the market and loan terms.
• 30-Year Fixed-Rate Mortgage: Offers steady monthly payments over a 30-year term, more affordable payments as compared to mortgages with shorter terms.
• 15-Year Fixed-Rate Mortgage: Lets you pay off your home loan faster and reduce your interest payments over the life of the loan.

While an Interest-Only mortgage is a good fit for some, not everyone can make such a mortgage work. It is important that you do your research and talk to professionals to figure out which loan type will fit your needs. There are also many alternatives to Interest-Only mortgages.

Alternatives can include:

Conventional loan: A Conventional loan is not insured or guaranteed by the government. This means it has fewer limitations and restrictions, which allows lenders some flexibility in the terms and conditions they set for their borrowers. Conventional loans typically require a down payment of as little as 3% of the total cost of the home.

Lenders can offer flexible term lengths on Conventional loans, ranging from 10 to 30 years. Since lenders are at a higher risk with a Conventional loan, the borrower may be required to secure private mortgage insurance (PMI) if they have a down payment of less than 20%.

PMI will no longer be required once a borrower reaches 20% equity in the home.

FHA loan: An FHA loan is a mortgage insured by the Federal Housing Administration. The FHA is a federal government agency that is part of the Department of Housing and Urban Development. FHA loans are backed by the federal government and are often a valuable option for homebuyers who do not qualify for a Conventional loan.

FHA loan requirements vary depending on individual loan types but require as little as 3.5% down payment on a home purchase. FHA loans may be a valuable option for first-time homebuyers, buyers with a lower credit score, or a challenging credit history.

One thing to consider: FHA loans require both an upfront payment for mortgage insurance and separate monthly mortgage insurance payments for as long as the life of the loan, depending on the loan-to-value ratio.

Housing Assistance Programs: Determining if you qualify for community housing programs that offer low interest rates or smaller fees for those wanting to purchase their first home - making owning a home more affordable.

Considering other angles: These can include things like taking the time to save for a bigger down payment so you can borrow less up front or buying a less expensive house. Buying a less expensive house at first can allow you to build equity, after that you can purchase a larger and more expensive home.

If you are unsure if an Interest-Only loan is right for you, New American Funding can help you determine other loan products or paths available to you. We are happy to service your loan and our loan officers are available to give you more information, answer any questions you have, and help you find which offered program is right for you. You can also use our online tools like our mortgage calculator to help you calculate a budget for your new home.

Is an Interest-Only mortgage a good idea?

Whether or not an Interest-Only mortgage is right for you will depend on your individual needs and circumstances. Each loan product is different and is designed with different financial situations and goals in mind. Contact a lender today to discuss your goals and see if an Interest-Only mortgage suits your needs.

What is the downside of an Interest-Only mortgage?

The main downside of an Interest-Only mortgage is that you are not building equity in your home while you are making interest-only payments. You don’t start building equity in your home until you begin paying down the principal amount.

What credit score do you need for an Interest-Only mortgage?

Generally, an Interest-Only mortgage will require a good credit score to qualify for them. A good credit score is usually between 670-739. Most lenders will want to see a credit score of around 700 for an interest-only loan. However, all lenders have their own individual requirements, so make sure you check with your lender.

Can I sell my house if I have an Interest-Only mortgage?

You can sell your house under an Interest-Only mortgage. However, you need to keep in mind that while you’re only making payments on the interest and not the principal you aren’t actually accruing equity in your home. So, if you try to resell when your home has depreciated, it may end up costing you money.

How long can you keep an Interest-Only mortgage?

Interest-Only mortgages are structured so that the period where you are only paying interest lasts from 5-10 years. After that the mortgage adjusts to a Fixed-Rate or Adjustable-Rate mortgage.

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