How Do Interest-Only Mortgages Work?

Introduction to Interest-Only Mortgages

An interest-only mortgage is a mortgage in which a homeowner only pays the interest on the monthly mortgage payment. The principal, the amount the loan is actually for, will not be paid down for a certain period of time. Most interest-only mortgages are interest-only for five to 10 years. That means that after the interest-only period is over, the homeowner will have to begin paying the principal and the interest in her monthly mortgage payment.

A Comparison of Interest-only and Fully Amortizing Mortgages

A comparison of interest-only mortgages and fully amortizing mortgages will help you understand exactly how an interest-only mortgage works. For example, suppose a homeowner borrows $300,000 from the bank at a 30-year fixed rate of 6.5 percent. An interest-only mortgage's monthly payment would be $1,625. However, a fully-amortized loan, which is a loan that includes principal in the monthly payment, would be $1,896. Therefore, the interest-only loan will make the homeowner's payments smaller by $271 each month.

Some Things to Consider with an Interest-Only Loan

The $271 savings per month may sound quite appealing to those trying to save money. However, in the long run, you will end up paying a considerable amount more. There are two reasons for this. First, the principal will not decrease during the interest-only period. Secondly, once the interest-only period is over, your monthly payment will be higher than a fully amortized loan payment after the same number of years because the interest will be calculated for the whole loan amount. That is, a homeowner paying a fully amortized loan will slowly decrease the principal, which will in turn decrease the interest.

There are several advantages and disadvantages to obtaining an interest-only mortgage. It is important to discuss this decision with a financial adviser to determine what type of loan may be most suitable for you.