What Is an Interest-Only Loan
And How Does It Work?
An interest-only mortgage offers a strategic route to property ownership with lower monthly payments. It has a unique structure and comes with potential risks. Let’s look at how these loans work and who they work best for.
Interest-Only Loans 101
An interest-only loan is a mortgage that lets borrowers pay just the cost of borrowing – the interest – for an initial period, typically five years. However, the interest-only phase could be anywhere from three to ten years.
During those first years, monthly payments are significantly lower than on a comparable traditional mortgage. They’re lower because the borrower isn’t paying down the loan amount (the principal). This is unlike a traditional mortgage in which you pay down interest and principal from the start.
After the initial period, most interest-only loans enter a phase where payments increase considerably to cover both principal and interest.
A common structure for this type of loan is a 30-year term with a five-year interest-only phase, followed by a 25-year principal-and-interest phase.
How does an interest-only loan work?
Most interest-only loans are structured as a hybrid of a fixed-rate and an adjustable-rate mortgage (ARM). For the interest-only period, the loan typically has a fixed rate, which is often lower than that of a comparable traditional 30-year fixed-rate mortgage. This helps keep the initial payments low.
When the initial period ends, and borrowers begin paying both principal and interest, the loan shifts to function like an ARM. This means the interest rate – and consequently your monthly payment – can fluctuate based on factors including U.S. Treasury yields, inflation, and government monetary policy.
Some interest-only loans are ARMs from the start, meaning the rate can fluctuate during the initial interest-only phase.
How much can the rate fluctuate? The loan agreement has caps that limit rate increases. A common cap structure is 5/2/1.
- 5% Lifetime Cap: The maximum the rate can ever rise above the initial rate.
- 2% Initial Adjustment Cap: The maximum the rate can increase the first time it adjusts.
- 1% Subsequent Periodic Cap: The maximum it can increase in each following adjustment period.
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Interest-Only Loans for Investment Properties
An interest-only loan can be a powerful tool for real estate investors looking to maximize cash flow with short-term rentals. Platforms such as Airbnb and Vrbo often generate significantly higher rent than long-term rentals. With an interest-only loan, an investor can keep their monthly payments low and their income from rent high for years. That cash flow can be redeployed to purchase additional investment properties.
A common structure for an investment-focused interest-only loan is a 40-year term, with a 10-year interest-only period. During this decade, the borrower pays only the interest charges. While the initial interest rate on a 40-year loan may be slightly higher than a traditional 30-year mortgage, the payments are still considerably lower because they’re not covering the principal.
When/How should you use an interest-only loan?
Beyond investors, an interest-only loan can be a strong option for several owner-occupant scenarios.
- Irregular, High Income: If your income includes large, less-predictable commissions or bonuses, an interest-only loan might be ideal. For example, you might use an annual bonus to pay down the principal during the initial period. You can typically make these extra payments without penalty. During months when extra cash isn’t available, you have less financial strain with lower interest-only payments.
- Short-Term Ownership Plan: Will a job or life plans take you elsewhere in five or ten years? If you don’t intend to stay in the home long-term, you could benefit from lower payments and then sell the property before the higher principal-and-interest payments begin.
- A Transition Plan: This strategy commonly serves people nearing retirement, but anyone who is changing homes might benefit. In this scenario, homeowners buy their second home with an interest-only loan. They later sell their primary residence and use those proceeds to pay off the interest-only loan.
How do you qualify for an interest-only loan?
As they carry a higher risk, interest-only loans often have stricter qualification requirements than traditional mortgages. While standards vary, they generally fall along these lines:
- Strong Credit: Typically, you will need a credit score of 700 or higher. A higher score can help you secure better terms.
- Low Debt-to-Income (DTI) Ratio: Approval of an interest-only loan generally requires a DTI ratio of 43% or less.
- Substantial Down Payment: You should be prepared to make a down payment of at least 20%. Some mortgage professionals may require an even larger amount.
- Ample Assets and Cash Reserves: You may need to show significant cash savings and other assets, demonstrating you can weather financial setbacks.
- High Income & Cash Flow: A high monthly cash flow and a history of rising income make loan approval more likely.
Pros & Cons of an Interest-Only Loan
Carefully weighing the benefits and drawbacks is crucial when considering this type of mortgage.
Pros
- Lower Initial Payments: The most significant advantage is considerably lower monthly payments for the first years of the loan, freeing up cash for other financial goals.
- Cash Flow Flexibility: This can be especially helpful for the self-employed whose irregular income may not fit the strict monthly requirements of a conventional mortgage. You can pay more when income peaks and the minimum when cash flow is less.
- Potential Investment Returns: By saving money on monthly payments, real estate investors can redirect cash into other ventures – potentially earning higher returns than home equity growth.
Cons
- Minimal Equity Growth: During the years in which you’re not paying down the principal, you’re not building home equity. The only equity you will have during the initial period is the down payment and market appreciation.
- Payment Shock: When the loan shifts to principal-and-interest payments, your monthly costs can rise significantly. A common percentage increase for an interest-only mortgage payment after the initial period is 40 to 65% or more.
- Interest Rate Risk: Whether it occurs from the start or after the initial period, the interest rate and payment can rise in line with market rates. This could substantially raise your long-term costs.
Tailored for borrowers with unique circumstances and solid financial planning, an interest-only loan is a valuable financial tool that can be key to an asset management plan. To learn more about interest-only loans and possible alternatives, call us today at 1-888-505-8960 or connect with us online.