Everything You Need to Know About Interest-Only Mortgage Loans

Are you considering an interest-only mortgage loan? This type of loan can be a great option for some homebuyers, but it's important to understand how they work and the potential drawbacks before making a decision. An interest-only mortgage loan requires you to pay only the interest for a set period of time, usually five to seven years. After that period, you can refinance, pay off the remaining balance in a lump sum, or start making regular monthly payments. The advantage of a mortgage that only pays interest is that you can make low monthly payments for the first few years you own a home, but it has many drawbacks and mortgages that only pay interest are considered risky.

Here's everything you need to know about how they work and how you can qualify.

What is an Interest-Only Mortgage Loan?

A mortgage that only pays interest requires interest payments, that is, the cost of borrowing money during the first few years of the loan. After the interest-only period has elapsed, you can refinance or cancel the loan or start making monthly principal and interest payments. With a mortgage that only pays interest, you only pay interest for the first few years, not the principal.

This option is great if you're looking to own a home for the short term (perhaps to fix up a property and resell it) or are planning to refinance it in the near future. However, this approach is only suitable for some homebuyers, so it's critical to know what you're getting into. And, unless you chose to pay more during the interest-only period, you won't have accumulated equity in the home. When choosing a mortgage lender, some companies may allow you to get pre-approved for a mortgage loan. Learn more about the mortgage documents you might need when applying for a mortgage loan to ensure a smooth closing.

Types of Interest-Only Mortgages

Because hybrid mortgages often offer low starting rates, they may be tailored to your needs if you plan to sell your home before the interest rate is adjusted.

If you keep the mortgage, you're likely to pay more interest overall than you would with a traditional 30-year mortgage loan. This is in contrast to fixed-rate mortgages, which set a single rate that you'll pay for the life of the mortgage.

Example of an Interest-Only Loan

This is an example of an interest-only loan of what you would pay each month if you applied for an interest-only mortgage instead of a conventional mortgage. When Fannie and Freddie buy loans from mortgage lenders, they make more money available to lenders so that they can issue additional loans.

FHA Section 245 (a) Loans

FHA Section 245 (a) loans work similar to loans that only pay interest, and this type of loan gradually increases your payments over time. Similarly, Whitney Fite, loan specialist and senior vice president of Capital City Home Loans, says that the interest rate on a mortgage that only pays interest is approximately 0.125% to 0.375% higher than the rate of a fixed amortizable rate loan or ARM, depending on the details.

Most interest-only loans are structured as adjustable-rate mortgages (ARMs), and the ability to make interest-only payments can last up to 10 years. In a nutshell, an interest-only mortgage is one where you only pay interest during the first few years of the loan, making your monthly payments lower when you start making mortgage payments.

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