Interest-Only Mortgage

What Is an Interest-Only Mortgage?

Interest-only mortgages are mortgage loans in which the borrower is required to pay just the interest over a period.

But does this only mean that interest must be paid? It would have been incredibly satisfying if the situation unfolded as desired. Regrettably, things don't operate in that manner.

The principal amount will be paid either in a lump sum or in subsequent installments.

Interest-only mortgages require only the payment of interest during the introductory period, which is predetermined (typically five, ten, or more years). The interest rate on these types of mortgages is generally on the higher side.

These loans are structured as an interest-only adjustable-rate mortgage (ARM) in which you pay a fixed interest during the introductory period. After the principal + interest payment starts, the interest rates will start to vary.

Suppose you take a 10/1 Adjustable Rate Mortgage, It means that your introductory period, when you pay only interest, will be 10 years, and after that, the interest rate will be subject to change or adjustment once a year.

Typically the mortgage can be structured in two ways:

1. Pay interest for the introductory period; after the introductory period ends, you pay principal along with variable interest till the end of the term.
2. Pay the interest on the loan for the whole term and the principal at the end of the term.

The person taking a loan has a few alternatives at the end of its term:

1. To refinance the loan (with the possibility of getting it at a lower interest rate)
2. To sell the property for which the mortgage is taken
3. To pay a lump sum or pay interest and principal for the remainder of the period.

As a result, interest-only mortgages allow customers only to pay interest during the initial period. Following the interest-only period, the loan would be amortized over the remainder of the tenure, which can be paid in a lump sum or through the sale of the property.

Interest-Only Mortgages vs. Traditional Mortgages

Let’s highlight how an Interest-Only Mortgage differs from a Traditional Mortgage.

Traditional mortgages are loans that the borrower repays periodically, comprising both principal and interest. These payments gradually reduce the principal amount borrowed, building equity in the home over time.

For those who earn a good income and plan to remain at home for an extended period, conventional mortgages are usually the most reliable in terms of time commitments.

They provide the opportunity to accumulate equity and benefit from potential appreciation in the housing market. Traditional mortgages also offer the advantage of fixed interest rates, providing stability and predictability in monthly payments.

How to decide which mortgage to take?

One can look at various parameters while deciding on the type of mortgage. They are on the basis of the following:

1. Cash inflows and outflows

• Traditional Mortgage
  If you have a stable income and can afford a higher monthly payment now. With a stable income, you can comfortably make consistent monthly payments towards principal and interest, gradually building equity in your home.
• Interest-Only Mortgage
  An interest-only mortgage may be an attractive option for people who have fluctuations in income, struggle to make ends meet, or face low levels of today's earnings but expect them to rise further down the road.

2. Future Plans

• Traditional Mortgage: One must also consider using a traditional mortgage when you want to stay in your home for some time. Since you intend to live in the property for an extended period, it makes sense to establish equity through regular payments, taking advantage of the potential appreciation in the home's value over time.
• Interest-Only Mortgage: Interest-only Mortgages may be better suited to you if you are thinking about selling your house soon. This type of mortgage allows you to reduce your monthly payment in the short run while planning a property sale before its principal repayment period.

3. Expectations about the market

• Traditional Mortgage: If you and market analysts expect the housing market to be unstable, a traditional mortgage may be the preferred choice. To protect yourself from possible volatility in the market, you may choose a Fixed Rate Mortgage, which guarantees an unchanging interest rate. 

• Interest-Only Mortgage: If you and market analysts expect the housing market to be stable, an interest-only mortgage can be a viable choice. By keeping your mortgage payments low, you can allocate funds towards other investments or savings, taking advantage of a stable housing market to maximize your financial strategy.

Advantages of Interest-Only Mortgage

We're going to look at how interest-only loans can benefit borrowers in the next section.

1. Low Level of Monthly Cash Outflow

For Interest-Only Mortgages, the borrower shall only be required to pay monthly payments during the introductory period on the interest portion of the loan.

This means that the full EMI (Equated Monthly Installment) consisting of principal and interest will only be payable after the completion of this initial period.

2. Increased Savings in the Initial Period

By having lower monthly payments, homebuyers with interest-only mortgages have the advantage of increased cash flow during the introductory period. This surplus of funds can provide greater support in managing monthly expenses and can be utilized for saving purposes.

3. Freedom of Payments

Some interest-only loans allow borrowers to begin making full EMI payments earlier than initially decided. This gives borrowers the freedom to choose when they can afford to start paying the principal amount along with interest.

This arrangement enables the borrower to have more control over their mortgage payments. It adapts them according to their economic situation, regardless of changes in income.

4. Favorable for Young Buyers

Interest-only mortgages can be particularly favorable for young buyers, especially those who have recently entered the workforce and started with a lower salary.

For young professionals who prefer homeownership over renting an apartment, an interest-only loan allows them to manage their cash flow more effectively by deferring the larger principal payments to a later stage when their income is expected to increase.

This can provide a stepping stone into the property market while still having the ability to meet their current financial obligations and gradually build equity in the property over time.

Disadvantages of Interest-Only Mortgage

Like every coin has two sides, the concept of interest-only mortgages also comes with its share of disadvantages and potential drawbacks.

No Equity in the Property

Equity represents ownership of a property and can be used as an asset for future financial endeavors. Interest-only loans enable the borrower to pay interest on a loan that does not include any principal amount.

This means the borrower has built no equity in the mortgaged property over the introductory period. Without building equity, the borrower does not benefit from ownership and cannot accumulate wealth through property appreciation.

Uncertainty of Income

One drawback of an interest-only loan is its dependence on the borrower's capability to make timely principal payments. It may be difficult to fulfill these requirements if the borrower's income is not growing as anticipated.

Fluctuating Interest Rates

The interest rate may be adjusted and updated to align with the current rates as soon as a period passes during which it is necessary to make its primary payment for an interest-only loan. 

This adjustment will ensure that the loan can still take into account changing interest rates and reflect current market conditions. 

By making this adjustment, the lender can ensure that the borrower's payment structure remains in line with the current interest rate trends, potentially resulting in changes to the overall repayment obligations for the loan.

Unreliable Housing Markets

Housing markets can be volatile and impact your interest-only mortgage. Your home's value could decrease if the housing market continues to decline. It will be difficult to sell your house and pay off the mortgage. 

The 2008 crisis is an example of the same.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Loan Stress Test
• Loss Given Default (LGD)
• Maturity
• Maximum Loan Amount
• Microcredit