If you’re in the market for a house and are considering an “interest-only” mortgage, proceed with caution.

With tightened lending standards amid ongoing economic uncertainty — coupled with continually rising home prices and persistent low interest rates — some borrowers may gravitate to these so-called interest-only loans, experts say. These are loans where you only make interest payments on the balance for a set period of time. And while they may be suitable for some would-be homeowners, it’s important to understand both their pros and cons.

“There’s a small pool of buyers that could probably use this loan option,” said Al Bingham, a mortgage loan officer with Momentum Loans in Sandy, Utah. “But those payments will go up down the road if you’re only making the minimum payments.

“That can just add financial strain to consumers.”

Siri Stafford | Getty Images

As the coronavirus pandemic continues to act as a drag on the economy, the majority of lenders have tightened credit standards across all loan types, according to recent research from Fannie Mae, a government-sponsored enterprise that, along with Freddie Mac, backs mortgages that meet certain standards.

Interest-only mortgages fall outside that category, which means they are not broadly available. Lenders either keep these mortgages in their own portfolio or sell them to investors.

Generally speaking, interest-only loans of today come with stricter qualifications than the versions offered in the early 2000s. At that point, many came with loose qualifications — i.e., no income verification — or terms that ultimately left borrowers with an unaffordable mortgage. Those loans contributed to skyrocketing mortgage delinquencies, and foreclosures peaked in 2010 at more than 2.8 million, according to Bankrate.

One thing that’s happened since the subprime collapse in ’07 and ’08 is that lenders have gotten smarter about interest-only loans.

Kristopher Martin

Executive vice president at Oaktree Funding

“One thing that’s happened since the subprime collapse in ’07 and ’08 is that lenders have gotten smarter about interest-only loans,” said Kristopher Martin, an executive vice president at Oaktree Funding, a private mortgage lender.

“You have to qualify borrowers based on the [loan amount and payments] after the interest-only period,” Martin said.

Despite the name, the “interest-only” feature lasts just for a set amount of time — often seven or 10 years — at the beginning of the loan, not the entirety of it.

During that initial period, you are only required to pay the interest on the loan, not any of the principal. So unless you pay extra before that interest-free period is up, you will still owe the same amount on the mortgage as you did at the outset.

Because of the math involved in spreading out the amount over a shorter time period left on the full loan, your payment will rise. By how much depends on factors including the length of the loan and whether the interest rate is fixed or adjusts based on then-current rates (via a so-called adjustable rate mortgage, or ARM).

For illustration purposes only: If you got an interest-only loan at 4% on a $250,000 mortgage, and the introductory period was for 10 years, you’d pay $833 a month in interest. At the end of that, assuming you had paid nothing toward principal and the interest rate stayed at 4%, your payment would jump to $1,514 — a combination of interest and principal. (The calculation excludes any amount that goes into escrow for taxes and insurance.)

By comparison, a 30-year, fixed-rate $250,000 mortgage at 4% would result in monthly payments of $1,193 (both principal and interest).

Often, Oaktree does 40-year loans with the first 10 interest-only. When that time is up, the principal is spread out over 30 years — which then looks more like a traditional mortgage.

“What you don’t want to have happen is have a borrower who has payment shock of going from interest-only to fully amortizing over 20 years,” Martin said. “That’s a problem and what really hurts people.”

The loans that Oaktree offers typically come with an interest rate that’s about one-eighth to one-quarter of a percentage point higher than a traditional mortgage, Martin said.

The rate right now on a traditional 30-year fixed rate mortgage is 3.25%, according to Bankrate.

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In many markets, Wells Fargo — one of the largest in the mortgage industry — continues to originate interest-only loans (as well as other nonconforming mortgages) as it did before the pandemic hit the U.S., a spokesman said. However, they are only available for jumbo loans — in most places, that means a mortgage of more than $510,400 this year (although in high-cost spots, that threshold is $765,600). 

Customers need to have a strong credit history and cash reserves, and the required minimum down payment can range from 20% to more than 50%, depending on various factors including the size of the loan, the spokesman said. The interest-only period lasts for 10 years.

There are instances where this type of mortgage can make sense, said certified financial planner Kevin Gahagan, an advisor and principal at Private Ocean in San Rafael, California.

For example, he has recommended them in divorce situations where one spouse is buying out the other’s interest in the home, needs affordable payments and does not plan to stay in the home long-term. He’s also recommended them when the homeowner anticipates moving in a few years and just wants to reduce the cost of holding the property.

Nevertheless, Gahagan said, it’s important to fully understand the risks.

“Be very clear about your objective in considering an interest-only loan product and recognize the risk involved,” Gahagan said. “These are most appropriate for those whose holding period is expected to be less than the [interest-only] part of the loan.”

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