As its name implies, an interest-only loan is a loan where a borrower pays just interest for the first few years of the loan’s lifetime, known as the “interest-only period[1].” However, the borrower has the option to pay some of the principal even during this time frame instead of just making interest-only payments.

In real estate, an interest-only mortgage typically has a five- to 10-year interest-only period, with a total lifetime of 20 to 30 years. After the interest-only term ends, the borrower has several options:

• Refinance the mortgage.
• Renegotiate another interest-only period.
• Pay both the principal amount and the interest[2].

The borrowed money itself (the principal) is not repaid in an interest-only scenario. However, the borrower still needs to make principal payments after the interest-only window closes, or pay the principal balance after the end of the mortgage term in a lump sum payment[3]. Once the interest-only period is over, the interest rate may adjust, and the borrower starts paying toward the principal[4].

Types of Interest-Only Loans

There are two types of interest-only loans: adjustable-rate and fixed-rate loans.

With a fixed-rate interest-only loan, the borrower will pay an interest rate that does not change during the loan term. After the interest-only period, the person will continue making monthly payments at the same rate[5].

Adjustable-rate loans, meanwhile, have interest rates that change over time. It starts with a fixed interest rate that lasts for an initial period, ranging from a year to 10 years. After the initial period, the interest rate may go up or down based on current market factors. The interest rate will continue to adjust at set intervals thereafter, depending on the loan’s terms, until the loan is fully paid[6].

BY THE NUMBERS: The national average on a 30-year fixed-rate mortgage is above 4%.

Source: Bankrate

Here are some of the pros of interest-only loans[7]:

• Borrowers make lower monthly payments during the initial interest-only period. The borrower may use the extra time and money to save up or invest in income-producing ventures that can handle the increased payments down the road.
• A borrower can buy a property sooner than later.
• Investors may enjoy tax benefits or claim higher tax deductions for a rental property.
• It can be convenient for investors looking to sell the property within the interest-only period. They may benefit from lower overhead expenses, make a profit, and pay off the loan balance sooner.

Some drawbacks for interest-only mortgages include[8]:

• Borrowers do not build equity during the interest-only period other than the equity built up on their down payment because they are not paying down the principal. If the property’s value goes down, the borrower will end up owing the lender more than the property’s worth.
• Borrowers will have to make higher monthly payments in the long run. Once the interest-only period ends, they will be required to pay back the principal while still paying interest over the loan term. They risk defaulting on the loan if they cannot handle the monthly payments.
• If the interest-only mortgage has an adjustable rate, borrowers are at the mercy of market forces that may dictate higher interest rates over the loan’s lifetime.

Interest-only loans present a higher risk to lenders, so lenders have stricter qualification requirements than for a conventional loan[9]. Interest-only loans may also have higher interest rates than regular loans to offset some of the risk.

While the criteria may vary per lender, borrowers generally must have:

• Low debt-to-income ratio (preferably below 36%).
• Down payment of at least 15%.
• A FICO score of at least 700.
• Proof that the borrower has sufficient cash flow and/or assets to repay the loan[10].

In general, interest-only loans fit the income profile of people who know they can make money over time (such as investors targeting a more stable cash flow in a few years). Some investors may also find the low monthly payments appealing if they plan to flip the property once the interest-only period is over[11].

• An interest-only loan is a loan where a borrower pays only interest for a specific time frame, and the principal and the interest thereafter.
• The interest-only time frame typically lasts up to 10 years, but the borrower can pay both the interest and the principal during this time.
• Once the interest-only period expires, the borrower can either renegotiate the terms of the loan, pay the principal and the interest afterward, or pay the principal in a lump sum after the mortgage term ends.
• Since interest-only loans are riskier than traditional mortgages, lenders often require higher credit scores to qualify a borrower.
• Lenders will frequently charge a slightly higher interest rate as well.

1. Kagan, J. (2021.) Interest-Only Mortgage. Investopedia. Retrieved from https://www.investopedia.com/terms/i/interestonlymortgage.asp
2. Bowling, L. (2022.) What Are Interest-Only Mortgages And How Do They Work? Rocket Mortgage. Retrieved from https://www.rocketmortgage.com/learn/interest-only-mortgage
3. Chase.com. (n.d.) Interest-only loans vs conventional loans: What you need to know. Retrieved from https://www.chase.com/personal/mortgage/education/financing-a-home/interest-only-vs-traditional-mortgage
4. Corporate Finance Institute. (n.d.) What is an Interest-Only Mortgage? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/credit/interest-only-mortgage/
5. Quicken Loans. (2020.) Interest-Only Mortgages: The Facts And Alternatives. Retrieved from https://www.quickenloans.com/learn/interest-only-mortgages
6. Ostrowski, J. (2022.) Adjustable-rate mortgages: Learn the basics of ARMs. Bankrate. Retrieved from https://www.bankrate.com/mortgages/basics-of-adjustable-rate-mortgages/
7. Bundrick, H. (2022.) How Interest-Only Mortgages Work: Pros & Cons. NerdWallet. Retrieved from https://www.nerdwallet.com/article/mortgages/interest-only-mortgages-what-you-need-to-know
8. Gallagher, M. (n.d.) Disadvantages of an Interest-Only Mortgage. Home Guides SFGATE. Retrieved from https://homeguides.sfgate.com/disadvantages-interest-only-mortgage-9326.html
9. Kapfidze, T. (2020.) What Is an Interest-Only Mortgage and How Does It Work? LendingTree. Retrieved from https://www.lendingtree.com/home/mortgage/interest-only-mortgages/
10. Avila, S. (n.d.) Do You Qualify for an Interest-Only Mortgage Loan? Carlyle Financial. Retrieved from https://www.carlylefinancial.com/blog/do-you-qualify-for-an-interest-only-mortgage-loan/
11. Fontinelle, A. (2021.) What Is An Interest-Only Mortgage? Forbes. Retrieved from https://www.forbes.com/advisor/mortgages/what-is-an-interest-only-mortgage/