interest only loan

The Interest Only Loan Programs Are Coming Back. What You Need to Do to Qualify for a Mortgage with an Interest Only Payment?

Who doesn’t want a cheaper mortgage payment every month? One way to get a lower payment is to strip the home loan down to the bare bones. That’s what an interest-only mortgage loan is. An interest-only loan only requires payments on the interest that your lender charges. You are not paying back principal on the loan. Most interest only-loans are designed as adjustable rate mortgages with terms up to 10 years. After that, you are required to make fully amortized payments that are split between principal and interest payments, as with a standard mortgage loan.

For example, let’s assume you get an interest-only home loan for $500,000 with a rate of 5% for five years. The interest only payment is about $2080. After five years, it is common for the interest only loan to adjust. Let’s say it adjusts to 6%. It is still interest only but your payment is up to $2,500. The rate could continue to rise each year, and by year 10, you are required to make interest and principal payments. If the rate is 7% (rates during the height of the last real estate boom were over 6% so this is possible), your payment would be more than $3800 per month.

At the end of the 10-year period, you could possibly refinance the balance of the loan into a better interest rate in some situations. But this is only an assumption and is not a sure bet.

Who Qualifies for Interest-Only Loans?

Some people think interest-only loans disappeared after the last crash. They did for a time, but now you can get them again. Today, interest only loans require a bigger down payment, a lower debt to income ratio and a good credit score. You will usually need a FICO score of 700 or higher. Also, expect to need to show lenders that you can pay by showing a good amount of cash in the bank.

Borrowers for Interest-Only Loans

Many interest only mortgage loans are best for people who do not expect to be in the home for many years. For example, if you know you are going to live in a city for only three years, such as a military family who will move, you could make an argument for an interest only loan as a way to save big on your monthly payment. But people with more average incomes and less cash in the bank should keep in mind that you are not paying down principal and growing equity with an interest only mortgage. Building home equity is one of the ways the middle class builds wealth in America.

Many of the best borrowers for this type of loan have plenty of cash and investments and are in a stronger financial situation. For them, not building equity in their home is not a big problem. Typical characteristics of home buyers with interest-only mortgages are:

  • High cash flow every month
  • Variable cash flow, such as real estate agents or salespeople
  • Income that is rising over time
  • Ample cash reserves

An interest only mortgage can be a good move for the borrower who has the financial discipline to make principal payments every so often when the cash comes in. It also can work for the borrower who has a job where he is paid a lot with annual bonuses. Real estate agents who work on commission also may find an interest only home loan appealing.

Some couples who are getting closer to retirement may use an interest only home loan to purchase a second home. They would then sell their first home when they retire and move into their second home and pay off that loan.

Many mortgage experts say that few people should strongly consider interest-only loans. They are mostly best for people with more money and assets who are not dependent upon growing equity in their home to build wealth. For middle income borrowers, one of the most important aspects of owning a home is growing equity over time. You will not be able to do so with an interest only mortgage until you begin to pay down principal.

To sum up, these are the pros and cons of interest only mortgages:

Pros

  • You have a lower monthly payment during the interest only period
  • They are usually adjustable rate loans so your initial rate will be lower than a fixed rate

Cons

  • You are not gaining equity when you make interest only payments
  • If the market declines, you can lose equity that you obtained when you made your down payment
  • Unless you move, you will have larger monthly payments in future years
  • Some interest only home loans have large balloon payments later

Expect to need to have a bigger down payment, higher credit scores and more assets to qualify for interest-only home loans. If so, they can be a good financial tool for some borrowers.