Of all the pain points in the homebuying process, choosing a mortgage can be one of the most challenging. Many buyers, intimidated by the cost of the purchase and confused by the sheer number of mortgage options, choose the safe, predictable standard 30-year mortgage.
However, they may not realize that more novel types of mortgages can offer significant financial flexibility, potentially even allowing them to get more house for their money.
One of these unconventional mortgages is the interest-only mortgage. Interest-only mortgages were very popular before the Great Recession, but have become harder to qualify for since then.
Still, for certain types of earners, or for buyers with an appetite for moderate risk, an interest-only mortgage can be ideal. As an agent, educating your clients about the different financing options at their disposal can expand their range of possible homes and help you secure a sale. So, how do you position an interest-only mortgage to buyers, and what are the benefits and risks?
What is an interest-only mortgage?
An interest-only mortgage is a home loan in which the buyer pays only the interest at a fixed rate for a specified period, usually ranging from five to 10 years. However, they’ll still have to pay property taxes, homeowners’ insurance and, possibly, private mortgage insurance in their monthly payment, depending on the size of their down payment.
During that initial period, their monthly payments are lower because they’re only paying interest — they’re not paying anything on the principal loan amount. The appeal for buyers is clear: A lower monthly payment could allow them to buy a home that might otherwise not be affordable.
At a time when almost 70 percent of Americans think homeownership is unattainable for younger millennials, a financing option like this could be the difference between being able to buy into the market and having to wait another year. But it does come with risks.
After the interest-only period ends, they must begin to repay both the principal and interest, either in one large balloon payment or in the form of steeply increased monthly payments. For some homeowners, this could double or triple the amount they paid during the initial interest-only period.
Once those larger payments kick in, the homeowner may choose to renegotiate the terms of an interest-only loan if market conditions are favorable. They could also refinance to a conventional fixed-rate loan, but they should keep in mind that this will cost anywhere from 2 percent to 5 percent of the total loan amount, plus fees.
When you consider the complete terms of an interest-only mortgage, you start to understand the types of buyers who might benefit from this kind of loan.
Who should consider an interest-only mortgage?
An interest-only mortgage might be right for:
Earners who expect a big bump in income in the next five to 10 years: Individuals in line for a big raise may find interest-only mortgages appealing, since their future income can easily cover their increased mortgage payments.
People in line for an inheritance or other windfall: Likewise, an interest-only loan might be suitable for a buyer who expects to have access to a retirement account, inheritance, trust or other investments by the time the interest-only period expires.
Short-term homebuyers: Buyers who plan to sell or refinance their homes before the interest-only period concludes may benefit from lower initial payments. For example, an interest-only mortgage could work for buyers who have temporarily relocated for school or a job and expect to move again before the end of the introductory interest-only period. Similarly, house flippers may use an interest-only mortgage during the renovation to keep carrying costs down.
Investors with a strategic plan: Homebuyers who have a concrete plan to invest the money saved from lower monthly payments may find that interest-only mortgages align with their financial goals. However, careful consideration of market conditions and an understanding of their personal risk tolerance is key.
High-income households: Homebuyers who can afford the larger future interest and principal payment based on their current household income — not predicted future earnings — can safely opt for an interest-only mortgage.
Pros and cons of interest-only mortgages
Zoom out, and it’s pretty clear what the advantages and disadvantages of the interest-only mortgage are. As a real estate agent, you should be careful to explain both the positives and the negatives to any clients considering this kind of home loan. Let’s survey some of the main pros and cons of the interest-only mortgage.
Pros
- Lower monthly payments: Buyers who expect their future income to rise can buy a more expensive home than their current income allows.
- Financial flexibility: Buyers can use the money they’re saving on lower mortgage payments to invest elsewhere. If the return on investment exceeds the interest rate on the mortgage, this strategy could lead to financial gain.
- Tax deduction: Because the IRS allows you to deduct mortgage interest on your tax return, an interest-only mortgage could lead to significant tax savings during the interest-only phase of the loan.
- Increased accessibility: In markets with high property prices, interest-only mortgages can make homeownership more accessible. Buyers may use this option to enter the real estate market with the expectation of refinancing or selling the property before principal payments begin.
Cons
- Spiking payments: Once the interest-only period ends, borrowers must make significantly higher monthly payments that include principal and interest. This can catch some homeowners off guard, leading to financial strain if they haven’t adequately prepared for the increased expense.
- No equity: During the interest-only period, borrowers don’t build equity in their homes through principal payments. If property values decline or remain stagnant, homeowners may owe more than their home is worth, making it challenging to sell or refinance.
- Adjustable rates: Interest-only loans typically convert to an adjustable-rate mortgage at the end of the interest-only period, which means your interest rate could rise or fall with the market. Your monthly payments will increase or decrease accordingly. The year-over-year fluctuations can be significant, making it challenging for buyers seeking a predictable payment.
- It can be tough to qualify for: Lenders often have strict eligibility requirements for interest-only mortgages compared to traditional loans. Borrowers typically need a credit score of 700 or higher. If your credit has been negatively impacted by missed payments or cosigning a loan, you’ll have to work to get it back up. Borrowers also need a 20 percent down payment, a debt-to-income ratio of 43 percent or less, and proof of earnings and assets to qualify for an interest-only mortgage.
Ultimately, it’s up to the buyer to decide what kind of mortgage they want. The role of the agent here is to help them weigh the advantages of lower initial payments against the potential risks, ensuring that they have a comprehensive understanding of the long-term implications of an interest-only mortgage.
Luke Babich is the CEO of Clever Real Estate in St. Louis. Connect with him on Facebook or Twitter.
