The advantages and pitfalls of this niche mortgage product.
Though lenders tend to have tight qualifying guidelines for interest-only loans, there are still plenty of competitive offers out there. For investors, an interest-only mortgage can maximize returns and reduce payments in the short term. For home buyers, they can provide some breathing room early in the loan — though it'll cost more in the long run.
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How do interest-only mortgages work?
How do I get an interest-only loan?
Why would I want an interest-only mortgage?
How can I find the best interest-only mortgage?
Interest-only mortgages differ from standard mortgages in the way they're repaid. The monthly payments on a traditional home loan include both the interest and a portion of the principal. Interest-only home loans, on the other hand, repay only the interest of the loan for a fixed period — usually up to five years.
While you make interest-only payments, you'll have a lower monthly mortgage but won't be reducing the principal balance. After the initial interest-only period of the loan is up, payments increase and include payments to the principal. When that happens, some homeowners choose to refinance for more favorable terms.
How is interest calculated on a home loan?
How can I get an interest-only home loan?
Have a bigger down payment. Many banks are more willing to consider an interest-only home loan if you have a larger down payment. A bigger down payment — usually at least 20% — will make you a more attractive borrower.
Prove ability to pay. Before the market crash, home buyers only had to demonstrate that they could make the interest-only payment. Now, buyers must prove they can pay the full payment once the interest-only period ends.
Consider a non-bank lender. Non-bank lenders are unique in that they don't have the same restrictions and regulations as traditional banks. This allows them to be more flexible with their lending terms.
Many investors use interest-only loans because interest payments on an investment mortgage are tax deductible. Investors choose interest-only loans to minimize their monthly payments while maximizing cash flow and tax effectiveness. The risk with this strategy is that if property prices fall, you can end up in negative equity.
What if I'm an owner-occupier?
Interest-only mortgages might not be the best option if you're planning on living in your new home as a primary residence. For starters, banks are typically hesitant to approve interest-only loans for owner-occupiers. Their partial reasoning is that if you can't afford to make principal and interest payments, you're likely trying to borrow more than you can afford.
One of the main dangers of owner-occupiers using an interest-only home loan is that the payments can rise dramatically when the loan reverts to principal and interest.
However, an interest-only mortgage could be a good option for first-time home buyers who plan on moving or refinancing before the interest-only period ends. It's also a good option if your income fluctuates — you can always pay more when you can.
What are the pros and cons of interest-only loans?
Lower payments. With an interest-only mortgage, you won't have to pay toward the principal balance.
Tax savings. If you're an investor, your monthly mortgage payments may be tax-deductible.
Need to refinance. Interest-only periods generally last about five years. After that, you may have to refinance to another lender if you wish to continue making interest-only payments.
Market risk. Interest-only loans can be higher risk than principal and interest loans, as you're not building equity in the property. In other words, if property values decrease, you could end up owing more than your property is worth.
Fees. Look for an interest-only mortgage with low upfront and ongoing fees.
Interest rates. Interest rates are slightly more important when comparing interest-only home loans, as there's no principal repayment. The full amount of your monthly payment will be based on the interest rate you're paying.
Features. The ability to make extra payments, bring your loan with you to a new property or split your loan into fixed and variable portions might be important.
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Though they're a solid option for many borrowers, interest-only loans are not without their risks and potential pitfalls. Do your diligence by comparing mortgages to find the one that's right for you.
What is a split-rate mortgage?
A split-rate mortgage divides your loan into different portions, allowing you to get a loan with an interest rate that's partially fixed and partially variable. This provides some of the advantages of a variable-rate loan, such as interest rates that can decrease over the course of a year, with some of the advantages of a fixed rate home loan, like protecting yourself from rising rates.
Note that some home loans will only allow for two splits. Others allow you to split your loan into as many as five or even six portions.
My lender is raising rates. Can I refinance my interest-only mortgage?
If you have an interest-only loan but aren't investing, it's likely a good idea to switch to a principal and interest loan. The right decision for you will depend on your financial goals and circumstances.
Can a broker help me get an interest-only mortgage?
Interest-only loans can be harder to obtain than principal and interest loans. A good mortgage broker should be able to connect you with the right lender for your situation.
Jing Jun Ma is the innovations expert at finder.com. With nearly a decade of experience in digital marketing and programming, Jing is our tech and data guy. He develops strategy and teases relevant data into useful pages for readers across our site, among other projects companywide.