The Basics of How an Interest Only Mortgage Works

If you’re house hunting these days, you may have come upon a popular loan known as the interest only mortgage, often referred to as an I-O for short. An interest only mortgage is a type of mortgage loan in which the borrower makes monthly payments on the loan’s interest and not the principal for a set period of time.

Interest Only Mortgage Loan Definition

Interest only mortgages are also called delayed amortization loans because the loan amortizes after the initial interest only period expires. When this occurs, the loan will automatically revert to the original interest rates and terms of the contract. If you have secured a 30-year mortgage with a five year interest only agreement, as is the typical scenario, the amortization of your loan will be delayed by the interest only period.

Interest Only Mortgage Loan Example

With a typical mortgage, you’d make a monthly payment that contributes to both the principal balance and the interest you also owe. This is how an interest only mortgage differs from traditional mortgage options, drawing on the above example:

Let’s say you buy a home for $300,000. You put down $50,000, so the total amount you have to borrow from the bank, credit union or other lending institution totals $250,000. That is the principal balance of your loan. However, the lender also charges you interest on that $250,000.

For the first five years, you make interest payments only. The principal balance remains untouched. Then, when the interest only mortgage agreement matures, your 30-year mortgage now fully amortizes over a period of 25 years.

When that happens, your monthly payment can grow considerably as there is less time to pay off the original principal balance of the loan. The introductory terms for these types of loans vary by interest only mortgage lender. Regardless of when that maturity period occurs, homeowners need to brace themselves for the increase payment amounts.

If you’re temporarily tight on cash, but will see an increase in income in the future, an interest-only mortgage may be right for you.

Before committing to an interest only loan, be sure to consult with a financial expert. He or she can walk you through your options and help you decide if this kind of loan is right for you. You may find that an interest only mortgage might be perfect for your needs.