An interest-only mortgage lets borrowers pay only the interest on the loan for an initial period, typically 5 to 10 years, without reducing the principal balance. After this interest-only period ends, payments include both principal and interest over a shorter amortization term, often leading to significantly higher monthly payments. This jump in payments, known as payment shock, can strain budgets, sometimes increasing payments by 40% or more.
During the interest-only phase, borrowers do not build equity since the principal remains unchanged. This exposes them to negative equity risk if home values fall or stagnate, meaning they owe more than the home is worth. Negative equity can prevent refinancing or selling without bringing extra cash.
Refinancing is a common strategy to manage payment shock, but if a borrower’s financial situation worsens or home prices fall, refinancing may not be possible. Increased interest rates can also make new loans unaffordable, leaving borrowers trapped.
The ultimate risk is foreclosure, which can occur if borrowers cannot afford the higher payments, cannot refinance, and cannot sell their home.
Interest-only mortgages were prevalent before the 2008 housing crisis but remain available under stricter regulations today, usually as non-qualified mortgages requiring better credit and income documentation.
These loans may suit financially sophisticated borrowers who have a clear plan for managing future payments, such as high-net-worth individuals, disciplined investors planning short-term ownership, or borrowers with guaranteed lump sum income. However, first-time buyers, those on tight budgets, or less financially savvy borrowers should avoid them.
For safer home financing, understanding related concepts like payment shock, negative equity, and foreclosure can help. Also explore our guide on various mortgage types to find the best fit for your financial goals.
Example: On a $400,000, 30-year loan at 6% interest with a 10-year interest-only period, initial monthly payments would be about $2,000 (interest only). When principal payments begin afterward, monthly payments jump to roughly $2,866, a 43% increase, which many borrowers find difficult to sustain.
Sources:
- Consumer Financial Protection Bureau, Interest-Only Mortgages
- NerdWallet, What Is an Interest-Only Mortgage?
- Investopedia, Interest-Only Loan