Interest-Only Mortgages

In many markets, home values have appreciated considerably. These higher home prices have prompted many home shoppers to look for new ways of making their dream home a reality. To many, interest-only mortgages seem to be one way to make buying a higher priced home more affordable. Unfortunately for potential home owners, interest-only mortgages are not exactly what the name indicates.

What is an interest-only mortgage?

Contrary to what some may believe, an interest-only mortgage is not a separate type of mortgage. Instead, an interest-only mortgage is a mortgage option that a lender can combine with any type of conventional mortgage. For example, a 30 year fixed mortgage can have a five year interest-only option attached to the first five years. This option, like with most mortgages, requires that the borrower, usually over the course of many years, pay back the principal amount owed plus interest.

The key difference between the interest-only mortgage option and conventional mortgages is that payments toward the principal amount owed can be delayed for a certain period of time. Payments toward the principal amount owed can be delayed for anywhere from 5 to 15 years, during which only payments toward interest are made -- hence the name interest-only mortgage. After the interest-only period has ended, payments toward principal begin by following an amortization schedule (an amortization schedule can be created using our free mortgage loan calculator).

Delaying payments toward principal can result in a significant amount of money being saved during the interest-only period. For example, a five year interest-only mortgage option attached to a $200,000 30 year fixed mortgage, with an interest rate of 4.75 percent would require monthly payments of $791.67 during the first five years. A 30 year $200,000 mortgage at 4.75 percent would require monthly payments of $1,043.29 for the life of the loan.

An interest-only mortgage option attached to the 30 year mortgage in our example would save you $251.62 ($1,043.29 minus $791.67) per month during the interest-only period. How much will the monthly payments be after the interest-only period ends? Using the example above, a five year $200,000 interest-only mortgage with an interest rate of 4.75 percent, which becomes a fixed 25 year mortgage after the first 5 years, the monthly payments would increase to $1,140.23.

As mentioned earlier, after the interest-only period has ended, mortgage payments increase due to the mortgage fully amortizing. To reduce the extent to which payments increase after the interest-only period has ended, additional payments toward principal can be made, when possible, during the interest-only period. Most interest-only mortgage options allow this, which has made the interest-only option attractive to those who receive bonuses or have higher seasonal earnings.

Next: Who might benefit the most from an interest-only mortgage?

Updated: July 2006