When searching for a home loan, an interest-only mortgage loan is one possibility you might consider. This type of mortgage doesn't require you to make principal payments initially. Instead, you just make payments toward the interest on the loan.
That's a big difference compared to a traditional 30-year fixed mortgage, which amortizes principal and interest across the life of the loan. If you are interested in an interest-only loan, the tips below could help you decide if it is right for you.
How do interest-only mortgages work?
Conventional loans require you to make payments toward the interest and principal for a set term, usually 15 years or 30 years. At the beginning of the loan term, most of your loan payment goes toward the interest. As you near the end of a 15-year mortgage or 30-year mortgage, the bulk of your payment goes to the principal loan balance.
Interest-only mortgages allow you to make loan payments toward the interest during the first part of your mortgage term. For example, you might make interest-only payments for the first five to 10 years. Interest-only loans can have mortgage rates that are fixed rates or adjustable rates. Once the initial interest-only term ends, you'd continue making payments toward the loan with both principal and interest amortized.
An interest-only mortgage is a type of nonconforming home loan. That means they aren't backed or insured by Fannie Mae or Freddie Mac. Interest-only mortgages are less common than other types of home loans and not every financial institution offers them. You can get in touch with Credible's experienced loan officers to get answers to your mortgage questions, including more on how interest-only mortgages work and what types of mortgages are available to you.
Should you get an interest-only mortgage?
Getting an interest-only home loan can offer advantages for some buyers, though there are some considerations to keep in mind. It's helpful to weigh the pros and cons to decide if it's a good fit.
Interest-only mortgage pros:
- Lower payments: Because you're initially only paying toward the interest, your monthly payments might be lower compared to a traditional 30-year mortgage.
- Preserve cash: Lower monthly payments may leave you with more cash on hand to invest or spend on home improvements.
- Paying down principal balances is optional: Though you're not required to pay anything toward the principal balance of your loan amount during the interest-only period, you could choose to do so to reduce what you owe.
- Potentially easier qualification: Since interest-only mortgages aren't subject to conforming loan rules, lenders can set their own guidelines for approving borrowers.
Interest-only mortgage cons:
- More expensive: An interest-only mortgage might not affect what you pay toward the down payment or closing costs, but you could pay more interest over the life of the loan.
- Slow to build equity: Since you're not paying anything toward the principal on the loan, you're not building any equity through your payments during the interest-only period. The silver lining is that rising home prices boosted home equity by 16.2% in 2020, according to CoreLogic. That can help you build home equity even when you aren't paying on the principal.
- Higher payments later: Once the interest-only period ends, you could see your monthly payments increase substantially.
- Balloon payments: Depending on how your mortgage loan is structured, you may be responsible for making one large balloon payment at the end of the loan term.
Do you qualify for an interest-only mortgage?
Since interest-only mortgages aren't government-backed, lenders can set their own standards for approval. For instance, lenders may accept borrowers with lower credit scores if they have a steady monthly income, substantial cash in savings or a higher net worth.
But is an interest-only mortgage right for you? You might consider this type of home loan if:
- You're buying the home as a short-term investment
- You need cash to pay for home improvements or renovations
- You plan to pay the mortgage off early
- You need a temporary mortgage option because you're buying a new home while selling one you currently live in
- You're getting divorced and need a short-term mortgage solution to buy out a spouse who co-owns the property
You may also consider an interest-only mortgage if you're confident that you'll refinance to a conventional loan down the line. Credible can help you compare multiple mortgage lenders at once and see your loan options in just a few minutes.
There are many pros and cons, and interest-only mortgages aren't for everyone, but they can offer some great benefits for those who qualify. And qualifying for these loans could be easier since they aren't conforming loans, and backed by Fannie Mae or Freddie Mac. If you're seeking lower monthly payments, easier qualification based on credit history or short-term cash savings, an interest-only home loan could be the right mortgage option. You can use Credible's online mortgage calculator and other tools and get prequalified today.
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