How do interest-only mortgages work?
Interest-only mortgages can offer homebuyers lower payments initially, but they could cost more than a traditional loan in the long run.
Updated 
8 min. read
If you're planning to buy or refinance a home, researching different types of mortgages is an important step. One loan option you might consider is an interest-only mortgage.1
Interest-only mortgage loans allow you to make just interest payments for a set time period. Once the interest-only period ends, you would begin making regular principal and interest payments.
Understanding how interest-only mortgages work can help you decide if one might be right for you.
What are interest-only mortgages?
Interest-only mortgages allow you to make payments toward the interest on your loan initially, with nothing going toward the principal. That means that your loan balance doesn't go down during the interest-only period. With a traditional mortgage arrangement, the payment is split between the interest and principal each month, which lowers your balance.
Why would someone choose an interest-only mortgage? There are a few scenarios where it could make sense:
- You're planning to sell the home once the interest-only period ends.
- You need a smaller monthly payment initially.
- You've got sufficient cash reserves to make higher payments later or pay the balance off in full.
Calculating interest-only mortgage payments is fairly straightforward. You simply need to know the amount of the loan and the interest rate on the loan. Checking current mortgage rates can give you an idea of what you might pay, based on the amount you plan to borrow.
The amount of time that you'll spend making interest-only payments can depend on the loan terms, with the typical range being three to ten years.
Pros and cons of interest-only mortgages
An interest-only mortgage could make sense for some homebuyers more than others. In terms of the pros, here are some of the best reasons to consider an interest-only mortgage.
- Initial monthly payments are lower compared to traditional mortgages.
- Lower payments can leave you with more money in your budget to manage expenses each month, pay down debt, or invest.
- You have the option to make extra payments to the principal during the interest-only period, which can reduce what you owe.
- Mortgage interest may be deductible on your tax return, which could reduce your tax liability.2
- Interest-only loans are typically structured as adjustable-rate mortgages, which may result in interest savings, depending on the rate environment.3
Now, why might a homebuyer think twice about an interest-only mortgage? Here are some of the drawbacks to weigh.
You're not building any equity by making interest-only payments, as the principal balance does not decrease.
Once regular monthly payments begin, they can be significantly higher, which could make budgeting more of a challenge.
An adjustable-rate mortgage may not work in your favor if rates climb higher and in general, you'll pay more in interest over the life of the loan.
If your home declines in value, any equity gained from making a down payment could be lost.
Lenders may have stricter requirements when approving homebuyers for an interest-only mortgage.
Getting an interest-only mortgage
Interest-only mortgages follow the same guidelines as other mortgages, in terms of what lenders consider for approval. That can include, but is not limited to:
- Credit scores
- Income and employment history
- Debt-to-income (DTI) ratios
- Savings and other assets
The difference is that lenders may scrutinize them more closely to better gauge a homebuyer's risk potential.
Here's what you have to keep in mind about interest-only mortgage loans. Once the interest-only period ends, your monthly payment goes up to account for the amount that you're now expected to pay toward the principal.
Lenders want to make sure that buyers can handle the higher payment when the time comes. For that reason, they may limit approval for interest-only mortgages to buyers who they're reasonably sure can afford the loan. For example, you might need to have: a minimum 700 credit score, a down payment equal to 15% or 20% of the purchase price, and a debt-to-income ratio below 36% to qualify.
If you're interested in learning how to get the best deal on an interest-only home loan, here are a few tips that can help:
Shop around. Lenders aren't all alike and it's important to see how different loan options compare. Getting rate quotes from multiple lenders can give you a better idea of what you might qualify for.
Improve your credit. A higher credit score could translate to lower rates for an interest-only mortgage loan. A difference of even a half or a quarter percentage point on your annual percentage rate (APR) could result in savings, so it's worth your time to make sure your credit is in good shape.
Check rate trends. As mentioned, interest-only home loans typically have adjustable interest rates. Looking at how rates are trending and whether they're likely to move up or down in the near future is helpful for determining whether the timing is right to get an interest-only loan.
Plan ahead. Once the interest-only period ends, you'll have to begin making regular principal and interest payments to the loan. Estimating those payments can give you a better sense of what you can truly afford and whether it might be in your interest to try refinancing the mortgage into a new loan when the time comes.
If you decide to move ahead with an interest-only mortgage, take time to read the fine print carefully. It's important to know how long your interest-only period lasts, what the regular payment will increase to.
Interest-only mortgages may save money, but don't forget the big picture
Getting an interest-only home loan could make sense if you're not planning to stay in the home long-term, or you're confident that you can manage a larger payment later in exchange for a smaller one now. Knowing how interest-only mortgage loans work can help you compare them to other mortgage options when deciding which path to take on your journey to homeownership.
Ready to discuss your homebuying or refinancing options? Talk to one of our mortgage specialists today.
F A Q s
Lenders may expect you to have more invested with an interest-only mortgage. For that reason, you may need to put a minimum of 15% to 20% of the purchase price down. The exact amount that you'll need for a down payment can depend on the lender and your loan terms. Learn more about how down payments work when buying a home.
Once the interest-only period on your mortgage ends, you're expected to begin making regular monthly payments of both interest and principal. This payment may be substantially higher than the interest-only payment. If you're able to do so, you could choose to refinance the loan into a new mortgage or pay the entire balance in full.
If you're interested in buying or refinancing a home that you plan to live in long-term, then an interest-only mortgage might not be the best choice. On the other hand, if you're only planning to stay in the home for a few years then choosing an interest-only home loan could save you money if you have a lower monthly payment to make during the initial interest-only period.
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Have questions?
- Footnote 1 details. With an interest-only mortgage, your initial interest rate is fixed for a short period of time, after which it will convert to a variable rate and adjust semi-annually during the life of your loan if the index changes. Once the loan converts to a variable rate, interest rates and payments may vary. Changes to your property taxes and hazard, flood, or other required insurance may cause your total monthly mortgage payment to change periodically during the term of your loan. The minimum monthly interest-only payment can only be made in the first 10 years of your interest-only mortgage. Historical performance of interest-only mortgage indexes does not predict future performance and is only one factor to consider when choosing a mortgage loan. Interest-only loans provide for the payment of interest only for a set period of time, and payments of principal and interest thereafter for the remainder of the loan term. While making interest-only payments, principal is not reduced. At the end of this period, your monthly payment will increase, possibly substantially, because you will be required to pay down the outstanding principal plus any remaining interest. Always consider paying more than the minimum payment to pay down the principal. Your monthly payment amount may differ from this example based on your actual loan amount and repayment terms. Loan approval, certain restrictions and fees may apply.
- Footnote 2 details. BMO does not provide tax or legal advice. You should consult a tax advisor for information regarding any tax impacts associated with your loan.
- Footnote 3 details. Your initial interest rate is fixed for a short period of time, and then converts to a variable rate that adjusts during the life of your loan. The amount of your payments will change when the interest rate changes. Historical performance of Adjustable Rate Mortgage (A R M) indexes does not predict future performance and is only one factor to consider when choosing a mortgage loan. Certain restrictions and fees may apply.