Want a Lower Payment at First? Is an Interest-Only Mortgage Right for You?

How an interest-only loan works

Each normal mortgage payment has two parts. One part is interest, the cost of borrowing. The other part pays down what you owe. That second part is called principal.

With an interest-only loan, you pay just the interest for a set number of years. The Consumer Financial Protection Bureau says this time often runs from three to ten years. During that time, your payment is lower. But your loan balance does not go down at all. You owe the same amount at the end of those years as you did on day one, unless you choose to pay extra.

What happens when the interest-only years end

This is the part to plan for. When the interest-only time is over, you must start paying back the balance too. Most often, you pay it back over the years that are left on the loan. Since there are fewer years left to pay the same balance, the new payment can be much higher. This jump is often called payment shock.

The payment goes up even if the cost to borrow stays the same. Some of these loans can also change their cost to borrow over time. If that cost goes up too, the payment can climb even more.

When the low-payment years end, owners usually have a few choices:

• Start the higher payment and pay the loan down each month.
• Refinance into a new loan, if they qualify at that time.
• Sell the home or pay off the balance in one lump sum.

The CFPB gives a clear warning here. Do not count on being able to sell or refinance later. Home values can drop, and your income can change. If you could not afford the higher payment on today’s income, it may be wise to look at a different loan.

Who an interest-only loan can help

• People with income that comes in big chunks. Think of a doctor with a yearly bonus, a sales pro paid on commission, or a business owner. They can keep the monthly bill low and pay down the balance when the big checks come in.
• Buyers with plenty of savings. Some people would rather keep cash in the bank or invested than tie it up in the house.
• Owners who plan a short stay. Someone moving to Nashville for a three-year work assignment may want the lowest payment while they are here. They still need a backup plan in case the home does not sell fast.
• Investors buying rental homes. A lower payment can make the monthly numbers on a rental work better.

Who should think twice

• Buyers who need the low payment just to get by today.
• Buyers hoping prices will rise so they can sell or refinance later.
• Anyone who wants to build equity through their monthly payment.
• Anyone who would not be able to handle the bigger payment on their current income.

How lenders look at these loans

Federal rules say a lender must make a good faith effort to check that you can repay. For an interest-only loan, the lender has to look at the higher payment that comes later, not just the low one at the start. So the low payment does not mean you can buy a bigger home.

Interest-only loans also do not meet the rules for what the government calls a Qualified Mortgage. That means they are often found in the non-QM world, with their own rules. Many ask for a solid credit history, a good down payment, and savings left over after closing. Each lender sets its own terms, so it pays to compare.

Questions to ask before you choose one

• How many years will I pay only interest?
• What will my payment be when those years end?
• Can the cost to borrow change, and how high can it go?
• Can I pay extra toward the balance early with no fee?
• Is there a fee if I pay the loan off or refinance early?

Ask your loan officer to show you the payment both ways, side by side. Seeing the later payment on paper is the best way to know if you are ready for it.

A quick example

Picture a surgeon who just moved to Brentwood. Her base pay is steady, and she gets a large bonus each spring. An interest-only loan keeps her monthly payment low. Each spring, she puts part of her bonus toward the balance. By the time the low-payment years end, she owes less and the new payment is easier to handle. Now picture a buyer who picks the same loan only because the full payment is too high. When the low years end, that buyer could be in a tough spot. Same loan, very different fit.

Tips for agents

• Listen for big-bonus and commission buyers. They may be a good match, and many have never heard of this option.
• Do not lead with the low payment. Point buyers to a loan officer who can walk through the later payment too.
• Plan for more paperwork. Non-QM loans can ask for extra papers, so build a little extra time into the contract if you can.

Common questions

Wondering if an interest-only loan fits you?

Reach out through our contact page and we will connect you with a Heathrow Mortgage loan originator. You can also start an application online.