What You Should Know About Interest-Only Mortgages, According To Experts

Are you in the process of purchasing a home and looking to get the lowest monthly payment possible? Perhaps you're considering buying a home but only living there for a short time before selling it and moving on, or you're hoping to improve your credit score in order to get a lower rate when you refinance in a few years. The Consumer Financial Protection Bureau recommends that borrowers compare all mortgage options available to them by comparing loan types and terms as well as different types of interest rates. There's a wide range of loan options available today, and many people think fixed-rate and adjustable-rate mortgages are their only options. One type you may have heard of but not know much about is an interest-only mortgage. Renewed attention regarding these loans may have you wondering if one could be helpful to you.

As a consumer, it's worthwhile to consider this and other types of loans to determine which will fit your financial situation right now and into the coming years. Joshua Massieh, CEO of Pacwest Funding, and Alex Byder, owner of BD Home Holdings, LLC, provided some insight into what interest-only loans are and who may be a good candidate for them in an exclusive interview with House Digest.

You may read about an interest-only mortgage online or your banker may recommend it as an alternative to traditional fixed-rate and adjustable-rate loans. Unfortunately, there's a lot of miscommunication out there about exactly how they work. Joshua Massieh shares a clear explanation of what this financial tool actually is. "Each month, the borrower will pay only the interest on the loan. No payment will go towards the borrower's principal (original loan amount), so when they go to refinance or sell the home, the principal balance of the mortgage will be the same."

By contrast, in a traditional mortgage loan, each monthly payment is split between the mortgage principal and interest components. In the case of an interest-only loan, you end up paying only the interest over the lifetime of the loan's initial period and, therefore, do not build any equity in the home. The best way to understand the implication is to see how it works. "For example, if you are taking out a $500,000 interest-only loan, your monthly payments will not go towards paying down the $500,00 principal balance — [they] will only [be applied to] the accrued interest," explains Massieh. "When a payoff of the loan is ordered, the balance will be the $500,000 plus any current interest and fees due."

Typically, because borrowers are only paying the interest on the home loan, the monthly payment is attractively low, and that's enticing for first-time home buyers. From a mortgage lender's perspective, Joshua Massieh adds, "We typically see interest-only loans as short-term options for borrowers looking to keep their payment low until they can qualify for a more favorable principal/interest loan or for investors that are looking at keeping their fixed costs as low as possible."

Why the newfound focus on interest-only mortgages, then? According to Massieh, there's a good reason for consumers to consider them more frequently. "Over the last several months, as interest rates have risen, we have seen an increase in borrowers looking for alternative options to keep their monthly payment low, and therefore we have had a lot more talk about the interest-only product." It's undeniable that interest rates have gone up significantly. In early January 2022, indicates Forbes, the average 30-year fixed rate loan had an interest rate of around 3.22%. As of a year later, that has risen to more than double at 6.61%.

As you consider applying for a home loan, think about what your needs are, not just in the short term but also in the years to come. Sure, that low payment sounds like a blessing right now, but what happens later, after that initial interest-only period is over? The Consumer Financial Protection Bureau states that once that period ends, you must either pay off the loan in full, refinance it into another loan (provided that's possible), or start making payments towards the principal.

Alex Byder shares his opinion on what often happened with these loans. "While interest-only mortgages can be attractive, I do not recommend them to most people as they are an easy way to get sucked into a mortgage that you cannot really afford. Essentially, you have no problem making the interest-only payments but are overwhelmed once you start paying both principal and interest," he warns. "Additionally, most interest-only mortgages use adjustable rates, which means that the interest rate you pay can increase over time."