Interest-Only Loans: Are the Savings Worth It?

An interest-only loan (IO loan) lets you pay only interest for a set period of time ― instead of making payments that include principal and interest. Usually you pay only interest for the first few years of the loan, and then you start making payments that include both principal and interest for the remainder of the loan.

Interest-only loans can free up your cash for a few years since your interest-only payments will be lower than a traditional mortgage, where you pay interest and principal. However, you won’t be building equity since you’re not paying anything toward the principal. Plus, you could face a big increase to your monthly payment once the interest-only period ends. So, are the savings worth it? Here’s how to decide.

How does an interest-only mortgage work?

Interest-only mortgages work by dividing your repayments into two phases: the interest-only period and the amortizing period.

During the interest-only period of your loan, your principal loan balance won’t change. You won’t build equity in your home through mortgage payments, although you may still build equity if home prices are rising fast in your area.

During the amortization period, your payments will increase to cover both interest and principal amounts. Your loan balance will start to decrease, and you’ll build equity through loan payments in your home. However, because you’ll typically have fewer years than traditional mortgages to pay off the loan balance, your monthly payments will be higher unless you refinance or pay the loan off in full after the interest-only period.

Adjustable-rate mortgage vs. interest-only mortgage

Many people confuse adjustable-rate mortgages (ARMs) with interest-only mortgages. While these two mortgage types share some characteristics, they’re not the same. Interest-only loans are defined by the fact that you’re only paying the interest for a set amount of time. All interest-only loans are not ARMs, but some ARMs are interest-only loans.

ARMs are defined by the interest rate itself. Specifically, with an ARM, your interest rate will change over time based on broader market conditions. When your interest-only loan is structured as an ARM, you’ll likely face a rate adjustment after the initial period and have to pay principal along with interest once it ends.

While fixed-rate interest-only loans exist, many interest-only loans are in fact ARMs. These are commonly structured as 7/1 ARMs, 5/1 ARMs, or 3/1 ARMs, with the first number indicating the number of years the interest rate will be fixed and of interest-only payments.

For example, with a 5/1 ARM interest-only loan, you’ll make interest-only payments for the first five years of the loan. After that period, your interest rates will be adjusted once per year according to market conditions and you’ll have to pay principal along with the interest. That said, there is a lot of variability with how interest-only loans can be structured. Always consult with your lender to get a clear idea of all the options available to you.

Interest-only mortgages: Pros and cons

Interest-only mortgages have some benefits, but they also come with serious disadvantages that could prove risky. Here’s what you should know beforehand.

✅ Pros

• Lower initial payments: During the interest-only period, you could pay much less than you’d pay with a traditional mortgage. 
• Larger loan amount: Because you’ll be making lower monthly payments initially, you may qualify for a larger loan amount overall.
• Flexibility with payments: If you choose to, you can usually pay off your principal if you want, even during the interest-only period. This gives you flexibility with your repayments, especially if your income is unpredictable.
• Frees up cash for other investments: If you’re disciplined and financially savvy, you can invest the money freed up by lower interest-only payments into other opportunities with potentially higher returns.

❌ Cons

• Delayed equity building: During the interest-only period, you won’t be building equity in your home, which puts you at risk of being underwater on your mortgage.
• Higher payments later on: You could be in for payment shock when you have to start paying off your principal. Because you’ve missed time paying the principal, your monthly payments could increase dramatically.
• Harder to qualify for: Because interest-only loans are riskier, lenders generally require higher credit scores, larger down payments, lower debt-to-income ratios, and large cash reserves. Plus, many of the top mortgage lenders don’t offer interest-only loans, making them even harder to qualify for.
• Increased interest-rate risk: Because most interest-only loans are ARMs, you face payment increases not just from the principal but also from rising interest rates.
• More total interest paid: Because you’re not reducing your principal during the interest-only period, over the life of your loan you’ll likely pay a lot more interest compared to a traditional mortgage.

How do I pay off my interest-only loan?

You can pay off your interest-only loan by doing any of the following:

• According to your amortization schedule
• At the end of your loan term in one big payment
• Using a refinanced mortgage loan
• Using the proceeds from selling your home

Many borrowers pay off their interest-only loans by refinancing once the interest-only period is over. However, be aware that there’s no guarantee you’ll qualify for refinancing, especially if your financial circumstances change.

Similarly, banking on reselling your home when your interest-only period ends is risky. The market fluctuates and you could find yourself stuck trying to sell a house that is worth less than your total loan balance.

Some lenders let you pay only interest over the entire term of your loan, then pay off the principal at the end of your loan term in one big balloon mortgage payment. Since you'd need a lot of cash for this type of loan, balloon mortgages are much less common.

How do I sell my house if I have an interest-only loan?

An interest-only loan shouldn’t keep you from selling your home like normal.

However, interest-only loans don’t build equity during the initial period. If your home value goes down, you may end up selling your house for less money than you owe on your mortgage.

In that case, you’ll need to bring cash to your closing to pay off your loan balance.

If you don’t have enough financial resources to weather fluctuations in the market, then an interest-only mortgage is probably not right for you.

Is an interest-only mortgage a good idea?

An interest-only mortgage can be a good idea if you’re planning to move soon, such as military families, professionals in temporary job assignments, and house flippers. These types of buyers can take advantage of the lower payments without facing future increases.

Likewise, buyers who expect their income to grow significantly can use interest-only loans to afford a home now while knowing they’ll have the resources in the future to cover the larger payments.

However, interest-only loans can be risky for many other types of buyers. If you’re using an interest-only loan simply because you can’t afford a traditional mortgage, you’re setting yourself up for failure when your payments increase.

Also, if you’re staying in your home long-term or you’re in a declining or uncertain market, an interest-only loan means you won’t be building equity during the interest-only period. This could put you in a difficult spot if you have to resell since your home value could be less than your mortgage.

FAQ about interest-only loans