Interest-Only Mortgage

Interest-Only Mortgage: How It Works, Advantages, and Risks

What is an interest-only mortgage?

An interest-only mortgage lets you pay only the loan’s interest for a set period, producing lower monthly payments up front. After the interest-only phase ends, payments typically increase because you must begin repaying principal as well as interest. These loans can provide short-term cash‑flow flexibility but carry risks if you aren’t prepared for higher future payments.

Key takeaways

• You pay only interest for a defined introductory period; principal repayment begins afterward.
• Many interest-only loans are structured as adjustable-rate mortgages (ARMs) so interest rates can change.
• Interest-only payments don’t build home equity; payments can jump sharply when principal repayment starts.
• Borrowers should plan ahead for higher payments or have an exit strategy (refinance, sell, or lump-sum payoff).

How interest-only mortgages operate

• Typical structure: interest-only period of 5, 7, or 10 years, followed by conversion to a fully amortizing schedule that includes principal and interest.
• Common form: interest-only ARM — an initial fixed interest-only window, then periodic rate adjustments and amortization.
• Example: a “7/1 interest-only ARM” might allow interest-only payments for seven years; after that, the loan amortizes and the rate can adjust annually.
• Less common: fixed-rate interest-only loans that keep an interest-only feature for longer periods or the entire loan term; some loans require a balloon payment at maturity if principal wasn’t repaid.

Repayment options when the interest-only term ends

• Begin amortizing: monthly payments increase to repay principal over the remaining term.
• Refinance: replace the loan with a new mortgage, potentially extending another introductory period or switching to a fixed-rate loan.
• Sell the property: use sale proceeds to pay off the mortgage.
• Lump-sum payoff: pay the principal in one payment at maturity (possible only if you’ve saved accordingly or the loan allows a balloon).

Factors to consider before choosing an interest-only mortgage

• Payment shock: estimate future monthly payments after the interest-only period and ensure you can afford them.
• Rate risk: if the loan is an ARM, rising rates will increase costs when the rate resets.
• Equity and LTV: since you aren’t paying principal, you won’t build equity through payments; home price appreciation becomes the primary way to increase equity.
• Qualification and lender rules: some lenders offer IO loans only to certain borrowers and may impose strict underwriting or higher rates.
• Exit strategy: have a plan (refinance, sale, or savings) to handle the principal obligation when it comes due.

Pros

• Lower initial monthly payments, improving short-term cash flow.
• Flexibility for borrowers expecting higher future income or planning to sell before principal amortization begins.
• Can be useful for short-term investors or homeowners who prioritize liquidity.

Cons

• No principal repayment means no mortgage-driven equity buildup.
• Payments can rise substantially once principal repayment begins, increasing default risk.
• Interest rate adjustments (on ARMs) can raise costs unpredictably.
• Potential for a balloon payment if the loan is non-amortizing.

Bottom line

Interest-only mortgages can be a useful tool for short-term cash-flow management or specific financial strategies, but they require disciplined planning. Because they delay equity accumulation and can produce significantly higher payments later, they suit borrowers with a clear exit plan and confidence in future income or property value growth. Before choosing this product, compare alternatives (fixed-rate 15- or 30-year mortgages, shorter interest-only periods, or partial amortization) and model worst-case scenarios for payments and rates.