An interest-only loan is best for high-income borrowers, real estate investors, or those with fluctuating income who need to manage short-term cash flow, such as by lowering monthly payments for 5-10 years. It is ideal for individuals planning to sell or refinance within that period, anticipating significant future income increases, or aiming to maximize liquidity for other investments.
An interest-only mortgage starts with payments that only pay down the mortgage interest. Generally, this makes your monthly payments lower than a typical mortgage payment. This option is attractive for those who cannot afford high mortgage payments.
Pros. Lower repayments during the interest-only period could help you save more or pay off other more expensive debts. Short-term finance that covers the period between buying a new property and selling your existing property.
People with fluctuating income also like interest-only loans because they can make the interest-only payment when they're short of funds, and pay down the principal when they have more money like a bonus or commission payment.
Eligibility for Interest-Only loans depends on the property type, a minimum credit score requirement, and a specified amount of monthly reserves.
While an interest-only loan may sound appealing for people looking to keep their payments low, it can be more difficult to get approved and is typically more accessible for people with significant savings, high credit scores and a low debt-to-income ratio.
An interest only home loan may be suitable if you're looking for: A way to maximise your tax deductions as a property investor. A temporary way to reduce your outgoing expenses as well as manage a temporary income reduction (e.g. if you're receiving parental leave or paying educational costs while you're studying)
You'll need to be well-qualified to be approved for an interest-only mortgage. Banks generally look for borrowers who have: A credit score of 700 or more. A debt-to-income (DTI) ratio of 43 percent or less.
An interest-only mortgage payment on $200,000 depends on the interest rate, but at 5%, it's around $833/month (just interest), significantly lower than principal & interest payments, though you never build equity and pay more total interest over time, with later payments including principal. For example, at 3.25%, the initial payment is about $542/month for the interest-only period.
One major risk is that your monthly payments could increase significantly at the end of the interest-only period when you are required to start paying both principal and interest. Additionally, if your property's value decreases, you could find yourself underwater on your loan — owing more than the property is worth.
A line of credit is a good example of an interest-only loan. Because there are no principal payments, the monthly servicing requirements are low. They can also be paid back and then “redrawn” (meaning borrowed again) without penalty, making them highly flexible.
Disadvantages of interest-only loans
At the end of the term of an interest-only mortgage you will still owe the amount your originally borrowed. In an ideal world, when your interest-only mortgage ends, you'd have sufficient cash savings or investments to pay off the capital balance. But, unfortunately, this won't be the case for many borrowers.
With interest-only, you're only paying to borrow, not own. So, unless the market adds value to your home, you won't be building any equity. If prices drop, you could even end up owing more than your home's worth – a bit like paying rent but with a big bill waiting at the end!
First, Interest-only mortgages often require higher credit scores and lower debt-to-income ratios for approval. Most lenders want a credit score of at least 680, though some non-QM lenders may go lower, even down to 500, if other factors (like assets or cash flow) make up for the risk.
The 3-7-3 Rule in mortgages isn't a loan type but a federal timeline from the TILA-RESPA Integrated Disclosure (TRID) rule, ensuring borrower protection by mandating disclosures within 3 business days of application, a 7-business-day wait between the initial Loan Estimate and closing, and another 3-day wait if significant changes (like APR) occur, giving borrowers time to review costs before committing to a loan.
What are the benefits of interest-only mortgages? Some people like the flexibility to be able to make lower payments initially, and pay more when their income or savings increase near the end of their mortgage term.