Interest-only mortgages

#How an interest-only mortgage works

A normal mortgage is fully amortizing: each payment covers that month’s interest plus some principal, so the balance falls to zero by the end of the term. An interest-only mortgage splits the term in two:

1. The interest-only period — its length is set in your loan agreement; the example below uses ten years. You pay only the interest that accrues each month. Your balance stays where it started unless you choose to pay extra.
2. The amortizing period — the rest of the term. The loan recasts, and the full balance is repaid over the years that remain, which makes each payment larger than on a loan that amortized from day one.

Many interest-only loans are also adjustable-rate mortgages, so the rate can reset around the same time the principal starts, adding a second jump. See fixed vs adjustable-rate mortgages for how ARM caps work.

#The payment jump at recast

The jump is larger than many borrowers expect because the principal is squeezed into 20 years instead of 30. The mortgage payment calculator shows both payments if you enter the loan as 30 years and then as 20.

#Why interest-only loans aren’t Qualified Mortgages

Under Regulation Z, a Qualified Mortgage (QM) must have regular payments that don’t increase the balance and don’t let you defer repayment of principal, generally no balloon payment, and a term of no more than 30 years. An interest-only period defers principal, so an interest-only loan can never be a QM, whatever your income or credit. QMs also cap points and fees at 3% of the loan.

That doesn’t make interest-only loans illegal. Lenders can still make them under the ability-to-repay rule, which applies to most home loans. That rule says how to test an interest-only loan: the lender must check that you can afford the payment that repays the loan over the term remaining after the recast — $3,949 a month in the example, not $3,017. So an interest-only loan generally won’t help you borrow more; it changes when you pay principal, not how much you must earn to qualify — see debt-to-income ratio.

Because the lender doesn’t get the QM legal protection, non-QM loans often come with higher rates, larger down payments or stricter reserve requirements. Credit used mainly for business purposes, such as many investor loans, falls outside these consumer rules altogether — see DSCR investor loans.

#Who uses interest-only loans

• Borrowers with large but irregular income, such as bonuses or commissions, who pay the interest monthly and put lump sums toward principal when the money arrives.
• High-net-worth borrowers, often on jumbo loans, who prefer to keep cash invested and can pay off the balance from assets.
• Property investors, who care about monthly cash flow and plan to sell or refinance.
• Buyers expecting to sell within the interest-only period, who accept the risk that a sale may not happen on schedule.

Home equity lines of credit often work in a similar way: a draw period — 10 years in the CFPB’s example — with interest-only payments, followed by repayment. The HELOC payment calculator shows that jump.

#The risks

• Payment shock when principal kicks in, and possibly a rate reset at the same time.
• Refinancing risk — counting on a refinance before the recast depends on your income, credit, home value and rates at that time.
• Higher lifetime cost, because you pay interest on the full balance for longer.

#Alternatives to consider

If the goal is a lower required payment with flexibility, a standard 30-year fixed loan with extra principal payments in good months can give you some of the same control without the recast — the extra payment calculator shows the effect. If the goal is a lower start rate for a few years, a fixed-period ARM still amortizes from the first payment.