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How interest-only mortgages work
This niche mortgage product has finally made its way back onto the Canadian market.
Interest-only mortgages recently resurfaced on the Canadian market, and while they can save you money over the course of your mortgage, it takes careful planning and an excellent understanding of the strategy behind the use of this niche mortgage product. While you’ll pay thousands of dollars more in interest over the life of your interest-only mortgage, you could potentially offset (and even profit) from this loss by redirecting your cashflow elsewhere.
How do interest-only mortgages work?
Interest-only mortgages differ from standard mortgages in the way they’re repaid. The monthly payments on a traditional mortgage include both the interest and a portion of the principal. Interest-only mortgages, on the other hand, repay only the interest of the mortgage for a fixed period — usually up to five years.
While you make interest-only payments, you’ll have a lower monthly repayment amount but won’t be reducing the principal balance. After the initial interest-only period of the mortgage is up, your monthly payments will increase and will now include payments to the principal as well as interest. When that happens, some homeowners choose to refinance for more favourable terms.
How is interest calculated on a mortgage?
How can I get an interest-only mortgage?
Qualifying for an interest-only mortgage is not as easy as a traditional mortgage since it’s a far less popular product. If you can find a lender offering an interest-only mortgage, there are some things you can do to help your chances of getting approved:
- Have a bigger down payment. Many lenders are more willing to consider an interest-only mortgage if you have a larger down payment. While you’ll need a down payment of at least 20% to get an interest-only mortgage, the bigger the down payment, the better.
- Prove ability to pay. You’ll not only need to demonstrate that you can make the interest-only payment – you’ll need to prove that you can pay the full monthly payment once the interest-only period ends.
- Consider a non-bank lender. Non-bank lenders, including online lenders and credit unions, are unique in that they don’t have the same restrictions and regulations as traditional banks. This allows them to be more flexible with their lending terms.
Why would I want an interest-only mortgage?
- For investors, an interest-only mortgage can maximize returns and reduce payments in the short term. By redirecting your excess cashflow during the first five years of the interest-only period, you can bulk up other investments such as RRSPs.
- For homebuyers, an interest-only mortgage can provide some breathing room early on — especially if you have unpaid debts with higher interest rates or you’re self-employed with a fluctuating income. Since you’re not redirecting your cashflow, an interest-only mortgage will cost you thousands of dollars more in the long run – and you won’t be offsetting the higher cost.
- For rental property or business owners, an interest-only mortgage could help redirect the cashflow from rent or business income into other investments and allow you to take advantage of the mortgage flexibility by paying off lump-sum amounts of the mortgage each year without incurring penalties.
What are the pros and cons of interest-only mortgages?
- Lower payments. With an interest-only mortgage, you won’t have to pay toward the principal balance until the interest-only period is over.
- Usually fixed-rate. Interest-only mortgages are usually fixed-rate, and sometimes come with more competitive rates than traditional mortgages.
- Flexibility. Most interest-only mortgages have flexible repayment terms which means you may be able to pay up to 15% or 20% of your principal balance each year without incurring prepayment penalties.
- Free-up cashflow. During the interest-only period, you’ll have a lower monthly mortgage payment which frees up some of your cashflow. Using this excess cashflow to bulk up other investments or pay off higher interest debts can ultimately help you offset the total amount of interest you’ll pay over the life of this more expensive type of mortgage.
- Market risk. Interest-only mortgages are higher risk than traditional mortgages, as you’re not building equity in the property during the interest-only period. In other words, if property values decrease, you could end up owing more than your property is worth.
- Difficult strategy. If you’re looking to invest your excess cashflow elsewhere, you’ll need to make sure the return is greater than the extra interest you’ll pay over the life of the mortgage. Investing isn’t always smooth sailing – you’ll need to be prepared for any losses.
- Need to refinance. Interest-only periods generally last about five years. After that, you may have to refinance with another lender if you wish to continue making interest-only payments or you want a more competitive interest rate.
How can I find the best interest-only mortgage?
There’s no “best” interest-only mortgage, but there are different ways to find out if a mortgage is the right one for you. Compare the following factors on interest-only mortgages:
- Fees. Look for an interest-only mortgage with low upfront and ongoing fees.
- Interest rates. Since theres no principal payment during the first few years, interest rates are important. The full amount of your monthly payment during this time will be based on the interest rate you’re offered.
- Features. The ability to make extra payments without incurring penalties can save you thousands of dollars over the life of your mortgage – and can help you cut down on interest after the interest-only period is over.
Though they’re a possible option for strategic investors and homeowners looking to free-up cashflow for a few years, interest-only mortgages are risky and come with potential pitfalls. You’ll pay thousands of dollars more in interest over the life of your mortgage, but if you can strategically redirect your cashflow elsewhere, you could end up offsetting the costs and then some. Do your diligence by comparing a range of mortgages to find the one that’s right for you.
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