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What is an Interest-Only Mortgage?

An interest-only mortgage is a mortgage in which the borrower only pays the interest on the loan for a set period.

How Does an Interest-Only Mortgage Work?

In general, an interest-only mortgage means the borrower only pays the interest on the loan for a set period. The interest rate can be fixed or variable. The interest rate on an interest-only adjustable-rate mortgage, for example, corresponds to a specific benchmark (often the prime rate, but sometimes LIBOR, the one-year constant-maturity Treasury, or other benchmarks) plus an additional spread (which is also called the margin, and its size is often based on the borrower's credit score). The benchmark plus the spread equals the interest rate on the loan; it is called the fully indexed rate. Some ARMs offer a discounted index rate, also called a teaser rate, during the first year or so.

To understand how interest-only loans affect a borrower's payment, let's assume that a bank offers a \$100,000 mortgage to a potential borrower at 8%. The monthly payment would be \$733.77 -- of which \$666.67 is interest and \$67.10 of which is repayment of the original \$100,000 loan amount. But in an interest-only mortgage, the payment is only the interest portion: \$666.67. This reduces the borrower's payment, but it leaves the principal outstanding (and accruing more interest).

[If you're ready to buy a home, use our Mortgage Calculator to see what your monthly principal and interest payment will be.]

If the interest rate is variable and the interest rate goes to, say, 9%, the interest-only payment goes to \$750. In many cases, adjustable-rate mortgages have caps--limits on how high and sometimes how low the interest rate can go, and how much they can move in any one year, month, or quarter. In some cases, the interest rate will adjust only upward -- that is, borrowers will get no benefit if interest rates fall.

Why Does an Interest-Only Mortgage Matter?

Interest-only mortgages are risky temptations and generally a bad idea. The typical strategy behind taking an interest-only mortgage is that the borrower does not have the income to make a larger payment now but expects to have that income later. If the interest rate is variable, sometimes the borrower also thinks that interest rates will fall, making the payments lower later. Regardless, the borrower is not repaying any of the principal, and that principal will simply keep generating interest due from the borrower until it is repaid.

Interest-only mortgages can have complex implications. Thus, as is the case with any mortgage or other loan, borrowers must be sure to read and understand the lender's documentation and contemplate the implications of changes in interest rates. Borrowers should be sure they can handle the worst-case scenario of being forced to make the higher mortgage payments once they begin repaying the principal. In adjustable-rate mortgages, lenders are legally required to disclose how high the borrower's monthly payment might go, and that the original principal is just going to keep accruing interest until it is paid.