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How interest-only mortgages work
The advantages and pitfalls of this niche mortgage product.
Though lenders tend to have tight qualifying guidelines for interest-only loans, there are still plenty of competitive offers out there. For investors, an interest-only mortgage can maximize returns and reduce payments in the short term. For home buyers, they can provide some breathing room early in the loan — though it’ll cost more in the long run.
Interest-only mortgage lenders
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 home loan include both the interest and a portion of the principal. Interest-only home loans, on the other hand, repay only the interest of the loan for a fixed period — usually up to five years.
While you make interest-only payments, you’ll have a lower monthly mortgage but won’t be reducing the principal balance. After the initial interest-only period of the loan is up, payments increase and include payments to the principal. When that happens, some homeowners choose to refinance for more favorable terms.
How is interest calculated on a home loan?
How can I get an interest-only home loan?
Qualifying for an interest-only mortgage is not as easy as it was before the housing crisis, but there are some things you can do to help your chances:
- Have a bigger down payment. Many banks are more willing to consider an interest-only home loan if you have a larger down payment. A bigger down payment — usually at least 20% — will make you a more attractive borrower.
- Prove ability to pay. Before the market crash, home buyers only had to demonstrate that they could make the interest-only payment. Now, buyers must prove they can pay the full payment once the interest-only period ends.
- Consider a non-bank lender. Non-bank lenders 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?
Many investors use interest-only loans because interest payments on an investment mortgage are tax deductible. Investors choose interest-only loans to minimize their monthly payments while maximizing cash flow and tax effectiveness. The risk with this strategy is that if property prices fall, you can end up in negative equity.
What if I’m an owner-occupier?
Interest-only mortgages might not be the best option if you’re planning on living in your new home as a primary residence. For starters, banks are typically hesitant to approve interest-only loans for owner-occupiers. Their partial reasoning is that if you can’t afford to make principal and interest payments, you’re likely trying to borrow more than you can afford.
One of the main dangers of owner-occupiers using an interest-only home loan is that the payments can rise dramatically when the loan reverts to principal and interest.
However, an interest-only mortgage could be a good option for first-time home buyers who plan on moving or refinancing before the interest-only period ends. It’s also a good option if your income fluctuates — you can always pay more when you can.
What are the pros and cons of interest-only loans?
Pros
- Lower payments. With an interest-only mortgage, you won’t have to pay toward the principal balance.
- Tax savings. If you’re an investor, your monthly mortgage payments may be tax-deductible.
Cons
- Need to refinance. Interest-only periods generally last about five years. After that, you may have to refinance to another lender if you wish to continue making interest-only payments.
- Market risk. Interest-only loans can be higher risk than principal and interest loans, as you’re not building equity in the property. In other words, if property values decrease, you could end up owing more than your property is worth.
How can I find the best interest-only mortgage?
There’s no one best interest-only mortgage, but there are different ways to find out if a home loan is the right one for you. Compare interest-only mortgages on:
- Fees. Look for an interest-only mortgage with low upfront and ongoing fees.
- Interest rates. Interest rates are slightly more important when comparing interest-only home loans, as there’s no principal repayment. The full amount of your monthly payment will be based on the interest rate you’re paying.
- Features. The ability to make extra payments, bring your loan with you to a new property or split your loan into fixed and variable portions might be important.
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Bottom line
Though they’re a solid option for many borrowers, interest-only loans are not without their risks and potential pitfalls. Do your diligence by comparing mortgages to find the one that’s right for you.
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