An interest-only mortgage is a loan that is secured against real estate where payments are made solely to the interest and not principal. This means that the principal amount stays the same for the life of the mortgage. This allows for lower monthly mortgage payments. Interest-only loans are an excellent option for people that expect their income to increase in the future but need money quickly to meet their financial obligations. Interest-only mortgages are typically more expensive than traditional mortgages but cheaper than personal loans, such as credit cards.
Interest-Only Mortgages Explained
A traditional bank mortgage includes principal and interest payments. In a traditional mortgage, the payments will gradually reduce the loan’s principal. In contrast, an interest-only mortgage requires the borrower to only pay the interest due per month. The principal amount of the mortgage does not go down since none of the principal is being paid.
Interest-only mortgages do not have an amortization schedule. The payments are the same regardless of the term and payment schedule. Since the borrower is only paying interest the mortgage is much more affordable with lower monthly payments.
Common Uses of Interest-Only Mortgages
The money borrowed using interest-only loans can be used for a wide variety of purposes. Generally, they are used for issues that require more money than can be borrowed using a credit card or personal loan. Here are some common uses for the money that many borrowers have:
- Financing home repairs or renovations
- Paying college or university tuition
- Investing in a new business
- Putting a down-payment on the purchase of a new home
Pros and Cons of Interest-Only Mortgages and Loans
As with any type of financing, interest-only mortgages have their advantages and disadvantages. It is important to understand all the potential issues before signing up for this kind of loan.
- Monthly interest payments are lower than an amortized mortgage.
- Very good if this is a mortgage for 3 or fewer years.
- Good for people with erratic incomes.
- Good for a borrower with limited income at the time
- The borrower never pays off the mortgage principal
- The interest rate may go up in the future.
- Usually short-term mortgages
Interest-Only Mortgage Payments
Interest-only mortgages are typically offered by alternative lenders which able to offer many different payment options. Most borrowers opt for interest-only payments since it offers the lowest possible payments, but lenders can also arrange for principal payments at the borrower’s request. These lenders can accept payments on a bi-weekly or monthly, or yearly basis. Typically lenders prefer that payments are made via cheques or e-transfers.
Most interest-only mortgages have allowances for early repayment. Many lenders will provide options for annual and even semi-annual lump sum payments which can be used to reduce the principal. These payments allow the interest-only mortgage to be paid off in a fashion similar to a traditional mortgage.
Interest-Only Payments for Second Mortgages
Many interest-only loans are registered as second mortgages. This means that the loan is secured against a property with an existing first mortgage. By using real estate as security, lenders are able to offer rates lower than those charged by credit cards. Credit card interest rates can go as high as 29.9%, but an interest-only mortgage has an interest rate as low as 6.99%. Compared with credit cards, the interest savings of this type of mortgage can amount to thousands of dollars per year.
Interest-Only Mortgage Rates
The interest rates for interest-only mortgages are as low as 6.99% and can go as high as 12%. For arranging this type of mortgage, there are also fees charged by the broker, lender, lawyers, and appraisal company. These fees typically are 2% to 8% of the mortgage amount and can vary based on the size of the mortgage and the property. These fees are reflected in the annual percentage rate (commonly referred to as APR) in the lender’s mortgage documentation.
Calculating Interest-Only Payments
Since there is no principal to be paid, calculating the monthly payments on an interest-only mortgage is quite simple. The monthly payment is equal to the mortgage amount, multiplied by the interest rate, then divided by twelve. For an example interest-only mortgage in the amount of $100,000 with 12% interest the monthly payment is calculated as follows:
As you can see, the monthly mortgage payment on this example mortgage would be $833.33.
You can also use our interest-only mortgage calculator to determine what your mortgage payments will be.