Interest-Only Mortgage: How It Works, Pros and Cons

An interest-only mortgage lets you pay just the interest portion for an initial period (typically 5-10 years), with no principal reduction. After the interest-only period ends, payments increase significantly as you begin paying principal over the remaining term. A $400,000 loan at 7% has an interest-only payment of $2,333, but jumps to $2,995 when amortization begins. These loans suit specific situations but carry substantial payment shock risk.

How Interest-Only Mortgages Work

The Structure

Interest-only period:

Pay only interest (no principal)
Lower monthly payment
Loan balance stays the same
Typically 5-10 years

After interest-only ends:

Payments increase substantially
Begin paying principal + interest
Amortize over remaining term
“Payment shock” occurs

Payment Comparison Example

$400,000 loan at 7%:

Period	Payment Type	Monthly Payment
Years 1-10	Interest-only	$2,333
Years 11-30	Fully amortizing	$2,995
Increase		+$662 (28%)

Why the Payment Jumps

After interest-only ends:

You must now pay principal
Only 20 years remain (not 30)
Same balance amortized over shorter time
Results in higher payment

Types of Interest-Only Loans

Interest-Only ARM

Most common type:

Fixed interest-only period (5, 7, or 10 years)
Rate adjusts after fixed period
Payment increases from both principal and potential rate increase

Example: 10/1 IO ARM:

10 years interest-only at fixed rate
After year 10: Rate adjusts annually
Amortization begins

Interest-Only Fixed Rate

Less common:

Fixed rate for entire term
Interest-only for initial period
Then amortizes at same rate

Advantage: No rate shock, only payment shock

Jumbo Interest-Only

For high-value properties:

Often available on jumbo loans
Higher loan amounts
May have stricter requirements

Who Uses Interest-Only Mortgages

Appropriate Candidates

High-income, variable earners:

Commission-based income
Bonus-heavy compensation
Can pay extra when income is high

Investors:

Maximize cash flow
Tax deduction benefits
Plan to sell before amortization

Short-term owners:

Moving within 5-7 years
Don’t need to build equity
Want lowest payment now

Those expecting income increases:

Early career professionals
Business owners expecting growth
Can handle higher payments later

Poor Candidates

Living at payment limit:

Can barely afford IO payment
Won’t handle amortizing payment
Payment shock will cause stress

Long-term primary residence:

Want to build equity
Need forced savings
Planning to stay 20+ years

Those expecting income decline:

Approaching retirement
Career wind-down
Fixed income ahead

Pros and Cons

Advantages

Lower initial payments:

More cash flow flexibility
Lower housing cost initially
Can invest difference

Greater purchasing power:

May afford more expensive home
Lower payment allows higher price
(Risky reason to choose IO)

Flexibility:

Can pay extra when able
Lower required minimum
Manages cash flow variations

Tax benefits (if applicable):

Interest is deductible (if itemizing)
All payment goes to deductible interest
(Subject to mortgage interest deduction rules)

Disadvantages

No equity building:

Balance doesn’t decrease
Only appreciation builds equity
Risk of being underwater

Payment shock:

Substantial increase when IO ends
May be unaffordable
Forced to refinance or sell

Higher total interest:

Pay more interest over life of loan
Delayed principal = more interest cost

Qualification requirements:

Must qualify at amortizing payment
Stricter requirements overall
Need higher income/assets

Market risk:

If home value drops, no equity cushion
May owe more than home is worth
Harder to refinance

Interest-Only vs Traditional Mortgage

Side-by-Side Comparison

$350,000 loan at 6.5%, 30-year term:

Feature	Interest-Only	Traditional
Initial payment	$1,896	$2,212
Year 11+ payment	$2,669	$2,212
Balance after 10 years	$350,000	$285,000
Total interest (30 years)	$512,000	$447,000
Equity after 10 years	$0 (from payments)	$65,000

Key Differences

Monthly cash flow: IO is lower initially, higher later

Equity building: Traditional builds equity; IO doesn’t

Total cost: IO costs more in total interest

Risk: IO has payment shock; traditional is stable

Qualifying for Interest-Only

Stricter Requirements

Lenders apply more scrutiny:

Must qualify at fully amortizing payment
May require higher credit scores
More reserves often needed
Lower maximum DTI

Typical Requirements

Requirement	Interest-Only	Traditional
Credit score	700-720+	620+
Down payment	20-30%	3-20%
DTI (qualified at)	Amortizing payment	Actual payment
Reserves	6-12 months	2-6 months

Why Stricter?

Lenders know:

Payment will increase significantly
Borrowers need capacity for higher payment
Higher risk of default at adjustment
Less equity cushion if problems arise

Strategies for Using Interest-Only

Make Extra Payments

Just because you can pay less doesn’t mean you should:

Pay principal when you can
Treats IO as option, not requirement
Builds equity over time
Reduces payment shock

Investment Alternative

The theory:

Pay IO minimum
Invest the difference
Earn more than mortgage rate
Use gains to pay off later

The risk:

Investment returns aren’t guaranteed
Requires discipline
Market timing matters
Most people don’t actually invest the savings

Short-Term Strategy

If you know you’re moving:

Use IO for lowest payment
Sell before amortization begins
Accept no equity building
Home appreciation is your equity play

What Happens When IO Period Ends

Options at Transition

Continue with amortizing payment:

Accept the higher payment
Begin building equity
Most straightforward option

Refinance:

Get new loan with new terms
May restart IO period
Subject to market rates and qualification

Sell:

Pay off loan from sale proceeds
Move to new property
Common exit strategy

Pay down principal:

If you saved/invested wisely
Make lump sum payment
Reduce the amortizing payment

Payment Shock Planning

Before IO ends:

Know your future payment
Budget for the increase
Build reserves
Consider refinancing options

Interest-Only in Today’s Market

Availability

Less common than pre-2008:

Subprime crisis reduced availability
Stricter regulations
Qualified Mortgage rules apply

Still available through:

Jumbo lenders
Portfolio lenders
Private banks
Some credit unions

Who Offers Them

Traditional sources:

Large banks (for jumbo/wealth clients)
Credit unions (some)
Mortgage brokers (can shop)

Less common from:

Online lenders
Most conventional lenders
Government-backed programs (FHA, VA, USDA don’t offer IO)

Risks to Understand

Payment Shock

The biggest risk. If you can barely afford IO payment:

Amortizing payment will be unaffordable
May be forced to sell or refinance
Could lose the home

No Equity Growth

If home values decline:

You owe more than home is worth
Can’t refinance without cash
Can’t sell without bringing money

Rate Risk (with ARM)

If IO is paired with ARM:

Rate can increase at adjustment
Payment shock is doubled
Plan for worst-case scenario

Discipline Required

If using IO to invest difference:

Must actually invest (not spend)
Must earn decent returns
Must not touch investments
Most people fail at this

Alternatives to Consider

Traditional Fixed-Rate

For most borrowers:

Stable payments
Forced equity building
Lower total cost
Less risk

ARM Without IO

For short-term owners:

Lower initial rate than fixed
Amortizing from day one
Less payment shock risk
Builds some equity

40-Year Mortgage

For lower payment:

Lower payment than 30-year
Still builds equity (slowly)
Higher total interest
Less common, limited availability

Frequently Asked Questions

What is an interest-only mortgage?

A loan where you pay only interest for an initial period (5-10 years), with no principal reduction. After the IO period, you begin paying principal and interest, significantly increasing the payment.

Are interest-only mortgages still available?

Yes, but less common than before 2008. They’re primarily available for jumbo loans, through portfolio lenders and private banks. They’re not available on FHA, VA or USDA loans.

Is interest-only a good idea?

For most people, no. They’re appropriate for specific situations: short-term ownership, high-variable income or sophisticated investors. For typical homeowners wanting to build equity, a traditional amortizing loan is better.

What happens after the interest-only period?

Your payment increases substantially as you begin paying principal over the remaining term. A 10-year IO loan amortizes over the remaining 20 years, resulting in a higher payment than a traditional 30-year loan.

Can I pay principal during the interest-only period?

Yes. You can pay extra toward principal anytime. The IO feature is a minimum, not a maximum. Paying extra builds equity and reduces future payments.

How much does the payment increase?

Typically 20-40% depending on loan terms. The shorter the remaining term after IO ends, the higher the increase. Calculate your specific numbers before choosing IO.

Do I qualify at the IO payment or the amortizing payment?

You must qualify at the amortizing payment. Lenders want to ensure you can afford the higher payment that will eventually apply.