Interest-Only Mortgage: How It Works, Advantages, and Risks What is an interest-only mortgage? An interest-only mortgage lets you pay only the loan’s interest for a set period, producing lower monthly payments up front. After the interest-only phase ends, payments typically increase because you must begin repaying principal as well as interest. These loans can provide short-term cash‑flow flexibility but carry risks if you aren’t prepared for higher future payments. Explore More Resources
Key takeaways
* You pay only interest for a defined introductory period; principal repayment begins afterward.
* Many interest-only loans are structured as adjustable-rate mortgages (ARMs) so interest rates can change.
* Interest-only payments don’t build home equity; payments can jump sharply when principal repayment starts.
* Borrowers should plan ahead for higher payments or have an exit strategy (refinance, sell, or lump-sum payoff).
How interest-only mortgages operate
* Typical structure: interest-only period of 5, 7, or 10 years, followed by conversion to a fully amortizing schedule that includes principal and interest.
* Common form: interest-only ARM — an initial fixed interest-only window, then periodic rate adjustments and amortization.
* Example: a “7/1 interest-only ARM” might allow interest-only payments for seven years; after that, the loan amortizes and the rate can adjust annually.
* Less common: fixed-rate interest-only loans that keep an interest-only feature for longer periods or the entire loan term; some loans require a balloon payment at maturity if principal wasn’t repaid.
Repayment options when the interest-only term ends
* Begin amortizing: monthly payments increase to repay principal over the remaining term.
* Refinance: replace the loan with a new mortgage, potentially extending another introductory period or switching to a fixed-rate loan.
* Sell the property: use sale proceeds to pay off the mortgage.
* Lump-sum payoff: pay the principal in one payment at maturity (possible only if you’ve saved accordingly or the loan allows a balloon).
Factors to consider before choosing an interest-only mortgage
* Payment shock: estimate future monthly payments after the interest-only period and ensure you can afford them.
* Rate risk: if the loan is an ARM, rising rates will increase costs when the rate resets.
* Equity and LTV: since you aren’t paying principal, you won’t build equity through payments; home price appreciation becomes the primary way to increase equity.
* Qualification and lender rules: some lenders offer IO loans only to certain borrowers and may impose strict underwriting or higher rates.
* Exit strategy: have a plan (refinance, sale, or savings) to handle the principal obligation when it comes due.
Pros
* Lower initial monthly payments, improving short-term cash flow.
* Flexibility for borrowers expecting higher future income or planning to sell before principal amortization begins.
* Can be useful for short-term investors or homeowners who prioritize liquidity.
Cons
* No principal repayment means no mortgage-driven equity buildup.
* Payments can rise substantially once principal repayment begins, increasing default risk.
* Interest rate adjustments (on ARMs) can raise costs unpredictably.
* Potential for a balloon payment if the loan is non-amortizing.
Bottom line Interest-only mortgages can be a useful tool for short-term cash-flow management or specific financial strategies, but they require disciplined planning. Because they delay equity accumulation and can produce significantly higher payments later, they suit borrowers with a clear exit plan and confidence in future income or property value growth. Before choosing this product, compare alternatives (fixed-rate 15- or 30-year mortgages, shorter interest-only periods, or partial amortization) and model worst-case scenarios for payments and rates.