A lot of people think of interest-only mortgage loans the same way they think of the dodo bird. Exotic – and extinct. But this particular species of home loan still walks the Earth – and its numbers are growing.
Interest-only home loans are one of those mortgage products that were very popular during the housing bubble, but practically disappeared after the bubble burst. But many lenders are now offering them again.
To be sure, this is definitely what would be considered an "exotic" loan product. An interest-only mortgage is not for everyone. But for certain types of borrowers, particularly those with substantial but irregular incomes, they're almost ideal.
What is an interest-only loan?
Interest-only loans are those where you only have to pay the interest charges. You don't have to pay down the loan itself – for a time.
When you use an interest-only mortgage loan to buy a home, you typically have about 5-10 years when you only have to make interest payments. After that, you need to start making payments toward the loan principle. However, many borrowers like to refinance at that point into another interest-only mortgage, so they can keep making only interest payments.
So why would you do that? Who would never want to pay down their loan principle and build equity in their home?
A lot of high net worth borrowers, for one. They don't want to tie up a bunch of money in an expensive home – they'd rather have it invested and earning money for them. Having an interest-only mortgage allows them to do that – while still reaping the benefits of any increases in home value when it comes time to sell.
And since the interest paid on up to the first $1 million in mortgage debt is tax-deductible, a well-to-do couple using an interest-only home loan can write off most of their housing costs. Not a bad deal.
There's another type of borrower for whom interest-only mortgage loans make a lot of sense, and that's someone with substantial but irregular earnings – perhaps a small business owner or a salesperson who gets the bulk of their income from commissions or bonuses.
For this type of borrower, an interest-only mortgage allows them to make minimal monthly payments when they need to, and then make large payments against the loan principle when the money comes in. They're still paying off the loan, they're just doing it in irregular steps.
Other types of interest-only home loans
An interest-only mortgage doesn't have to be used to buy a home. In fact, the most common type, one that is readily available to average homeowners, is the home equity line of credit, or HELOC.
Home equity loans are a type of mortgage, because they're secured by your home as collateral. HELOCs are typically set up as interest-only loans during the draw period, when you can borrow against the line of credit. You're only required to pay the interest charges as long as the draw period lasts, though you can make payments against loan principle if you choose.
Another common use for an interest-only mortgage is as a construction loan, to cover the cost of a new home while it's being built. In these situations, a buyer will often take out an interest-only loan to cover the cost of the land, the materials, the contractors and the like. The loan is then structured to convert to a regular fully amortizing loan once the home is finished and the new owner takes possession.
For the remainder of this article though, we'll be talking about interest-only mortgages as they're used for home purchases.
Qualifying for an interest-only mortgage
It should be apparent that, when used for buying a home, interest-only loans are a product for financially astute borrowers. However, during the housing bubble years they were often marketed to less sophisticated borrowers whose were qualified for those loans based only on their ability to make the interest payments, rather than the interest and principle. Many of them lost their homes when the loans became fully amortizing and they could no longer afford the payments.
These days, interest-only mortgages are almost solely a jumbo loan product, used to purchase high-end homes priced above the lending limits allowed by Fannie Mae and Freddie Mac. They are usually structured as adjustable-rate mortgages (ARMs), although some lenders offer them as fixed-rate loans as well.
Obviously, borrowers need to be well-qualified to be approved for these loans. Interest-only mortgage lenders often require credit scores of 720-740 or above and a large down payment may be required as well – sometimes 30 percent or more. But some will allow 20 percent or less – as with any mortgage, it helps to shop around.
Income requirements don't vary that much from regular mortgages – lenders want to see a debt-to-income ratio of 43 percent or lower. Unlike the bubble years, though, you can't qualify based simply on the basis of your ability to cover the interest payments – you need to qualify based on your ability to cover the payments when the loan becomes fully amortizing, both principle and interest.
In addition, interest-only mortgage lenders will usually require that you have demonstrated financial reserves sufficient to cover your fully amortized mortgage payments for certain period of time. This may be as short as a couple of months, but some lenders may require reserves sufficient to cover payments for two or three years.
Interest-only mortgage rates
Interest-only home loans do not meet the criteria for Qualified Mortgages (QMs) as set forth by the Consumer Financial Protection Bureau (CFPB). In fact, those guidelines specifically exclude interest-only mortgages. As such, lenders offering them lose certain legal protections they would otherwise gain for ensuring the borrower has the ability to repay the loan. As a result, these loans have an added risk for lenders and their rates are priced somewhat higher as a result.
Interest-only mortgage rates are not necessarily steep. In some cases, they may be only a quarter of a percentage point more than what you'd pay on a comparable fully-amortizing jumbo loan. However, rates will vary significantly from lender to lender and depending on how well-qualified the borrower is. The better your credit score, larger your down payment and the more financial reserves you have, the more likely that lenders will be willing to offer you their best interest-only mortgage rates.
Interest only mortgage calculator
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