Interest only mortgage

What Is an Interest Only Mortgage?

An interest only mortgage is a type of loan where the borrower pays only the interest accrued on the principal balance for a specified initial period, rather than paying down both interest and principal. This arrangement means that during the interest-only phase, the borrower's monthly payments are lower than they would be with a traditional mortgage. This financial product falls under the broader category of mortgage finance. After the introductory interest-only period, which typically lasts between seven and ten years, the borrower must begin making payments that include both the principal and remaining interest for the remainder of the loan term. Alternatively, a lump sum known as a balloon payment might be due at the end of the interest-only phase to cover the entire principal balance.

History and Origin

Interest-only mortgages are not a new invention, with their origins tracing back to less-rigid jumbo mortgage markets, typically aimed at sophisticated investors who sought to deploy the principal portion of their payments into other investments.¹⁵ However, their popularity surged in the early 2000s, especially in the United States, where rapidly appreciating home values encouraged homebuyers to take on these loans, often to afford more expensive properties than they otherwise could with a traditional amortizing mortgage.¹³, ¹⁴ The lower initial monthly payment made them attractive. This widespread adoption, coupled with lax lending standards, contributed to the housing crisis of 2007–2008 and the subsequent Great Recession, as many borrowers found themselves unable to afford the significantly higher payments once the interest-only period ended. F¹¹, ¹²ollowing the financial crisis, regulators introduced stricter underwriting standards and affordability criteria. For instance, the Financial Conduct Authority's Mortgage Market Review in 2014 in the UK introduced new rules, making interest-only mortgages much rarer and typically available only to borrowers with clear plans to repay the capital.

⁹, ¹⁰## Key Takeaways

• Borrowers pay only the interest on the loan for an initial period, leading to lower initial monthly payments.
• The principal balance of the loan does not decrease during the interest-only period.
• After the introductory period, payments significantly increase to include both principal and interest, or a large balloon payment may be due.
• Interest-only mortgages carry higher risks, including the potential for negative amortization or being "upside-down" on the mortgage if property values decline.
  *⁸ Eligibility requirements for interest-only mortgages became much stricter after the 2008 financial crisis.

⁶, ⁷## Formula and Calculation

The calculation for the monthly interest-only payment is straightforward, based on the principal balance and the interest rate. Since no principal is being repaid, the interest payment remains constant each month during the interest-only period (assuming a fixed interest rate).

The formula for the monthly interest-only payment is:

Where:

• (\text{Principal Balance}) is the initial amount of the loan.
• (\text{Annual Interest Rate}) is the annual rate charged on the loan (expressed as a decimal).

Interpreting the Interest Only Mortgage

An interest only mortgage allows borrowers to manage their cash flow by deferring principal repayment. This can be interpreted as a strategic financial tool for individuals who anticipate a significant increase in income in the future or those who plan to sell the property before the interest-only period concludes. It can also be seen as a way to acquire a more expensive real estate asset with lower initial outlays. However, the interpretation must also account for the significant risk: without paying down principal, the borrower does not build equity in the home through payments, and they remain fully exposed to the initial debt amount. If property values decline, or if the borrower's financial situation changes, the transition to full principal and interest payments or the need for refinancing can become problematic.

Hypothetical Example

Consider a hypothetical scenario where a borrower takes out a $400,000 interest only mortgage with an annual interest rate of 6% for an initial interest-only period of five years.

1. Calculate the monthly interest rate:
   Annual Interest Rate / 12 = 0.06 / 12 = 0.005

2. Calculate the monthly interest-only payment:
   Interest-Only Payment = $400,000 * 0.005 = $2,000

For the first five years, the borrower would pay $2,000 per month. At the end of the five-year period, the principal balance of the loan would still be $400,000. If the loan then converts to a 25-year (300-month) fully amortizing loan at the same 6% rate, the new monthly principal and interest payment would be significantly higher, around $2,577.85, representing a substantial payment shock.

Practical Applications

Interest only mortgages can be utilized by specific types of borrowers for particular financial strategies. One common application is for real estate investors who intend to sell a property quickly, such as house flippers. They can minimize holding costs by paying only interest while renovating, aiming to sell at a profit before the principal repayment begins. Another group that might consider these loans includes high-net-worth individuals who prefer to keep their capital invested in potentially higher-return assets, using the lower interest-only payments to maintain liquidity for other investment opportunities. Additionally, some self-employed individuals with variable incomes might use them to manage cash flow, anticipating higher earnings in the future to handle the increased payments or pay off the principal. However, since the 2008 financial crisis, the regulations surrounding these loans have tightened considerably, with regulators like the Financial Conduct Authority implementing stricter affordability criteria to ensure borrowers have a credible repayment strategy for the principal.

⁴, ⁵## Limitations and Criticisms

Despite their potential benefits for specific borrowers, interest only mortgages come with significant limitations and criticisms. A primary concern is that they do not build equity through scheduled payments; the principal balance remains unchanged during the initial period. This lack of principal reduction means that if property values decline, borrowers can quickly find themselves in a situation of negative equity, owing more than the property is worth. This risk was a major contributing factor during the 2000s housing boom and bust.

³Another substantial criticism is the "payment shock" that occurs when the interest-only period ends and the loan converts to full principal and interest payments. The significantly higher monthly payment can become unaffordable, especially if the borrower's income has not increased as anticipated, or if market interest rates have risen. Such scenarios can lead to default and foreclosure. Lenders are now more diligent in assessing a borrower's ability to handle the higher future payments, often requiring a stronger credit score and a clear repayment strategy for the principal. T²he lack of amortization in the early years also means that, over the full life of the loan, the total interest paid can be higher compared to a fully amortizing loan, as interest continues to accrue on the full original principal balance for a longer period.

¹## Interest Only Mortgage vs. Amortizing Mortgage

The core difference between an interest only mortgage and an amortizing mortgage lies in how the principal is repaid.

While an interest only mortgage provides immediate cash flow benefits, an amortizing mortgage offers a more predictable repayment schedule and consistent equity accumulation over time. The "amortizing mortgage" ensures that by the end of the loan term, the entire debt is paid off, assuming all scheduled payments are made.

FAQs

Can you pay principal on an interest only mortgage?

Yes, most lenders allow borrowers to make additional principal payments even during the interest-only period. This can help reduce the overall principal balance and the total interest paid over the life of the loan, as well as mitigating the "payment shock" when the interest-only phase ends.

What happens at the end of the interest-only period?

At the end of the interest-only period, the loan typically converts to a fully amortizing loan, meaning your monthly payments will increase significantly to include both principal and interest rate for the remaining term of the loan. In some cases, a large balloon payment for the entire principal balance may be due.

Are interest only mortgages good for everyone?

No, interest only mortgages are not suitable for everyone. They are generally considered higher-risk products and are best suited for borrowers with specific financial goals, such as those anticipating a large future income increase, property investors with short-term holding plans, or high-net-worth individuals managing complex portfolios. They are less suitable for first-time homebuyers or those seeking long-term stability and consistent equity growth in their primary residence.

Is an interest only mortgage an adjustable-rate mortgage?

An interest only mortgage can be structured as either a fixed-rate mortgage or an adjustable-rate mortgage (ARM). If it's an ARM, the interest rate can change periodically even during the interest-only phase, further increasing payment variability. If it's a fixed-rate interest-only mortgage, the interest payment will remain constant during that initial period.