Interest-only mortgage
A home loan that lets the borrower pay only interest for an initial period, after which payments jump to cover principal too.
What it means
During the interest-only period, often 5 to 10 years depending on the loan, the payment covers just the interest, so the balance does not shrink. Afterward, the loan converts to full amortizing payments over the remaining term, which can mean a much higher payment.
Many interest-only loans have adjustable rates, adding rate risk on top of payment shock. These loans tend to suit borrowers with irregular or rising income, such as those paid largely in bonuses, or investors who plan to sell or refinance, and who understand that no equity is built through payments in the early years.
Example
Suppose someone borrows $400,000 at an illustrative 6% with a 10-year interest-only period. The payment is $2,000 a month for 10 years; then the full $400,000 must be repaid over the remaining 20 years, raising the payment to about $2,865.72.
How it’s used
- Borrowers with variable income who prepay when cash comes in
- Investors expecting to sell before the period ends
- Keeping early payments low for a short period
Strengths and weaknesses
Strengths
- Lower payments during the interest-only period
- Frees cash for other uses early on
- Principal can usually be prepaid voluntarily
Weaknesses
- No equity built through required payments early on
- Large payment increase when amortization begins
- Risky if home values fall or refinancing is unavailable
Related terms
Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.