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Interest-Only Mortgage

A unique type of mortgage that only requires the borrower to pay the interest on a mortgage, and not the principal

What is an Interest-Only Mortgage?

An interest-only mortgage is a unique type of mortgage that only requires the borrower to make regular interest payments on a mortgage without paying any of the principal amount. The payment terms usually last for a specified period, with a principal to be paid off at a later date in either monthly payments or a lump sum.

Such a type of niche mortgage is sometimes used by different prospective borrowers depending on their financial situation, and we will examine some possibilities and risks later in the article.

 

Interest-Only Mortgage

 

Summary

  • An interest-only mortgage is a unique type of mortgage that requires the borrower to only make regular payments on the interest on a mortgage and not the principal.
  • Interest-only mortgages are rarely utilized and are generally avoided by most borrowers and homebuyers. They carry with them inherent risks that traditional borrowers may not fully understand.
  • An interest-only mortgage, over its total duration, generally requires interest to be paid out at a higher rate.

 

Interest-Only Mortgages vs. Traditional Mortgages

The amount of the monthly payments on interest-only mortgages are lower than traditional mortgages, as when a traditional mortgage is being paid, the payments also include a portion of the principal.

For a substantial period, the interest accrued is the only amount being made on an interest-only mortgage. The table below simplifies the differences between the two for easy reference:

 

Interest-Only Mortgage
Traditional Mortgage
Payment terms that exclude the principalPayment terms that include the principal
Niche productCommonly used
More common among households with a sporadic incomeCommonly utilized by households with traditional income types (i.e., salary, hourly)
Higher than market ratesMarket interest rates


Interest-only mortgages, therefore, come with higher interest payment amounts as no principal is actively being paid down. Interest paid on the unpaid principal principle portion is on top of the payment they would pay in a traditional mortgage.

 

Risks of an Interest-Only Mortgage

Interest-only mortgages are rarely utilized and are generally avoided by the vast majority of borrowers and homebuyers. They carry with them inherent risks, and their unique payment structure often exposes the borrower to a tremendous amount of risk that they may not fully understand.

Individuals looking at interest-only mortgages may see the lower initial payments at first as a more viable payment option. However, they often do not understand that the products are more expensive over the long term. The better course of action for any home buyer usually is to create a stronger budget.

Even in the instance of sporadic yearly income, an individual understands how much they can afford monthly and how much additional they need to save in higher income months. The borrower can also choose to take out a traditional mortgage with a longer amortization period and thus may be easier to pay down.

In the early 2000s, home values saw monumental increases within the United States. It was not impossible for home values to quadruple in as little as a five-year time frame.

Many homeowners and prospective buyers turned to interest-only mortgages to better afford homes and found themselves undertaking tremendous risk. The loans were one of the contributors to the 2008 Global Financial Crisis, which was fueled in large part by the housing market correction in various states.

 

Related Readings

CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Accrued Interest
  • Interest Expense
  • Mortgage Rate
  • Interest Rate Risk