Interest-only mortgage benefits and risks [2023 update] Knowing how they operate and when they might be appropriate could help you make an informed decision. In this guide, we’ll discuss the pros and cons of interest-only mortgages, when they may be advantageous, and what the potential risk factors are.
What Is an Interest-Only Mortgage?
An interest-only mortgage is a loan where the borrower pays only the interest on the borrowed amount (the principal) for a certain period, usually 5 to 10 years. Your monthly payments are much lower during this time since you aren’t paying down the principal. When the interest-only period ends, you’ll start paying down both the principal and interest, usually resulting in higher monthly payments. If you’re new to mortgages, you can learn more about the steps to qualify for a mortgage.
Pros of Interest-Only Mortgages
Lower Monthly Payments
The biggest benefit of an interest-only mortgage is the lower introductory monthly payment. This can help unlock cash flow to cover other expenses or make investments during that interest-only period.
Flexibility in Financial Planning
For example, for those with fluctuating incomes — like the self-employed or commission-based earners — lower payments may provide financial agility when things are slow.
Opportunity for Investment
In reducing your housing expenses temporarily, you have more money to be able to invest elsewhere, where the return might be greater than the mortgage cost. This might be particularly useful if you’re also considering fixed vs. variable rate mortgages.
Short-Term Ownership Benefits
So if you’ll sell the property before the end of the interest-only period, or if you simply want lower payments and don’t care about cross-sale costs later down the line, it can be an attractive proposition.
Cons of Interest-Only Mortgages
Higher Long-Term Costs
After the interest-only period is over, your payments will increase a lot. If you’re not prepared, this can cause financial strain.
No Equity Building During the Interest-Only Period
Because you aren’t paying down the principal, you won’t earn equity in the home. This can be dangerous if property values fall.
Risk of Negative Equity
In a down market, you may owe more than the property is worth, which will complicate its sale or a refinance.
Higher Interest Rates
Interest-only mortgages tend to carry a slightly higher interest rate than traditional mortgages, adding to the overall cost of borrowing.
When Might an Interest-Only Mortgage Be Useful?
Short-Term Housing Needs
A functioning interest-only mortgage makes sense if you’re expecting to be in a property no longer than a few years because it allows you to keep expenses down for the duration of your stay.
High-Income Professionals with Future Earnings Growth
For people about to get a big bump in income, like medical residents or young professionals, lower payments can give them relief until their incomes rise, and they can afford higher payments.
Real Estate Investors
Investors may use interest-only mortgages to maximize cash flow from rental properties, particularly when property values are expected to rise. To understand more about getting approved for a mortgage as an investor, check out how to get approved for a mortgage in Canada.
Risks to Consider
Payment Shock
When the interest-only period is over, the increase in monthly payments can be dramatic. Without planning, this could result in financial strain.
Dependence on Property Appreciation
An interest-only mortgage basically bets that property values will always go up. If the market drops, it may be more difficult to refinance or sell the property.
Limited Availability
Interest-only mortgages are not available from all lenders, and qualifying for one typically means you must have a solid credit profile and large down payment.
Not sure if an interest-only mortgage is right for you?
If the risks of an interest-only mortgage are too great, consider these alternatives:
- Adjustable-Rate Mortgages (ARMs): These start with lower interest rates; however, these rates adjust periodically.
- Traditional Fixed-Rate Mortgages: Payments are high, but they will not change over the life of the loan.
- Hybrid Mortgages: Just as Japanese maple has hybrid varieties, some lenders offer loans that blend characteristics of fixed-rate and adjustable-rate mortgages, initially easing this payment burden.
Key Takeaways
Interest-only mortgages can also be a helpful tool in certain scenarios, providing lower initial payments and increased flexibility. But the risks — payment shock and no equity building, to name two — make them not right for many borrowers. A full assessment of your financial goals with a mortgage advisor will help to determine if this avenue is appropriate for your needs.
