What an interest-only mortgage is
For a fixed period at the front of the loan, commonly five, seven or ten years, the payment is one month of interest on the balance and nothing else. Nothing is applied to principal, so the balance at the end of that period is the balance at the start of it. Then the loan amortizes: the whole principal, untouched, over however many payments are left in the term.
That is the entire mechanism, and it explains the thing people find surprising later. A thirty year loan with ten interest-only years is not a thirty year loan with a cheap decade. It is a twenty year loan wearing a thirty year term, and the twenty years start after the balance has spent a decade standing still. The usual amortization arithmetic applies at the reset, to a balance a plain-loan borrower would have spent that decade shrinking.
It behaves differently month to month, too. An ordinary mortgage payment quietly shifts towards principal as the balance drops. An interest-only payment does none of that: it is the same figure in month one and in month sixty, because the balance it is computed on has not moved.
Who offers one now
Fewer lenders than in 2006, and for a specific regulatory reason. The ability-to-repay rule that took effect in 2014 defines a qualified mortgage, and an interest-only loan cannot be one. So an interest-only mortgage is a non-QM product, which means it sits outside the safe harbour most conforming lending is written into. In practice that leaves jumbo lenders, portfolio lenders keeping the loan on their own books rather than selling it, private banks, and some credit union and bank programs.
Non-QM does not mean loose. Underwriting is commonly tighter than on a conforming loan: larger down payments, more reserves, and documentation of the income or assets behind the file. A lender keeping a loan rather than selling it has every reason to be careful with it. Terms and availability move, so treat this page as mechanism rather than as an offer.
The payment shock is the whole risk
The reset is not a rate event. It is an amortization event, and it happens on schedule whatever rates do. The balance parked through the interest-only years has to be retired in the payments left, and there are fewer of them than the term implied. That alone moves the payment by a third or more on a ten and twenty split.
It is commonly worse than that, because interest-only loans are frequently adjustable-rate loans rather than fixed ones, and the two events can land in the same month: amortization starts and the rate adjusts. The 5/1 ARM structure is the familiar version of the rate half. Move the rate-after-reset field in the calculator above before deciding a reset is survivable, because the friendly default (the same rate afterwards) is not the likely case.
Worth naming what the reset is not: it is not a recast, which re-amortizes a loan downwards after a lump sum, and it is not a refinance. It happens by itself, on a date written in the note, and nobody has to approve it.
Not the same thing as negative amortization
These get confused constantly and they are different structures. An interest-only payment covers the month's interest exactly, so the balance stays flat. A negative amortization payment (the option ARM and payment-option loans of the 2000s) covers less than the interest, and the shortfall is added to the balance, so the debt grows while payments are being made. Interest-only is flat. Negative amortization is upward. The risk in the first is a payment that jumps; in the second it is a balance that climbs.
A worked example
$500,000 at 6.5%, ten years interest-only on a thirty years term. Round illustrative numbers, not a quote and not current rates.
| Structure | Payment now | Payment after the reset | Interest over the loan |
|---|---|---|---|
| Plain thirty years loan | $3,160 | Unchanged | $637,722 |
| Interest-only, same rate afterwards | $2,708 | $3,728 ($1,020 more, 38%) | $719,688 ($81,965 more) |
| Interest-only, rate moves to 8.5% at the reset | $2,708 | $4,339 ($1,631 more, 60%) | $866,388 |
| Interest-only plus $500 a month of principal | $3,208 | $3,281 ($72 more) | $652,988 |
Two things fall out of that. The first is the size of the step: $2,708 becomes $3,728 in one month, and no version of the structure avoids it. The second is what the low payment buys: $2,708 a month on a plain amortizing loan at the same rate and term carries about$428,488, so the structure is buying roughly $71,512 of extra borrowing at the same monthly outlay. That is the real pitch, and it is real, but it is borrowed against a payment that has not arrived yet. The payment calculator runs the plain version with taxes, insurance and dues folded in.
The last row is the lever inside the structure. $500 a month of voluntary principal brings the balance at the reset to $440,000, so $66,700 of the extra interest disappears and the jump collapses to $72. It works twice: it shrinks the balance the reset payment is computed on as well as the interest charged along the way. Check the note for a prepayment penalty first.
When the structure fits, and when it does not
- Irregular income. Commission, bonus, equity vesting, seasonal self-employment: a low required payment with principal paid in lumps when the money arrives fits that cash flow. Only if the lumps get paid.
- A known exit before the reset. A planned sale, a relocation on a fixed date, a refinance already underwritten. The structure is being used as a term loan with a real end date rather than as a mortgage.
- An investor on the arithmetic. A rental where the interest-only payment is what makes the property cash-flow positive, run as a deliberate trade of equity build for current yield. Buying a rental property covers the rest of that file.
- It does not fit when the interest-only payment is what makes the house affordable at all. The reset payment is the payment the loan requires, and it is a fully amortizing payment on a shorter schedule than an ordinary borrower carries. If that figure does not fit the budget today, the plan is that something changes in the meantime, and a plan that depends on rates, prices or income moving the right way is a bet rather than a plan.
- It does not fit when equity is the point. Ten interest-only years build equity only from appreciation, and appreciation is not owed to anybody. A flat market leaves the balance where it started.
Questions people ask
How is an interest-only mortgage payment calculated?
It is one month of interest on the balance and nothing else: the balance times the annual rate divided by twelve. On a $500,000 loan at 6.5% that is $2,708 a month. No principal is included, so the balance at the end of the interest-only period is the same as the balance at the start of it, and the payment does not fall over time the way an amortizing payment's interest portion does.
What happens when the interest-only period ends?
The loan starts amortizing: the full balance has to be retired over whatever payments are left in the term, so the payment is recalculated from the untouched balance over the shorter span. Ten interest-only years on a thirty year term leaves twenty years to repay the whole loan, which in the example above takes the payment from $2,708 to $3,728. If the loan is also adjustable, the rate can move in the same month.
Can you still get an interest-only mortgage?
They exist, and they are narrower than they were. An interest-only loan cannot be a qualified mortgage under the ability-to-repay rule that took effect in 2014, so it is a non-QM product: commonly jumbo lenders, portfolio lenders keeping the loan on their own books, and some private and bank programs aimed at borrowers with irregular income or large assets. Underwriting is generally stricter than on a conforming loan, not looser.
Is an interest-only loan the same as a negative amortization loan?
No. An interest-only payment covers the month's interest exactly, so the balance stays flat. A negative amortization payment covers less than the interest and the shortfall is added to the balance, so the debt grows while payments are being made. Interest-only is flat, negative amortization is upward, and only the second one can leave a borrower owing more than they borrowed.
Does paying extra principal during the interest-only period help?
It works twice. The extra reduces the balance the reset payment will be calculated on, so it cuts the reset payment as well as the interest charged in the meantime. In the example, $500 a month of voluntary principal brings the balance at reset to $440,000 and the reset payment to $3,281, which turns a $1,020 jump into a $72 one. Check the note for a prepayment penalty first: some non-QM loans carry one.
Arithmetic on the numbers you type, not advice, and not an offer or a quote from any lender. Whether an interest-only loan is available, at what rate and on what reset and prepayment terms, is set by the lender and by the note, and those govern. Figures in the worked example are round illustrative numbers, not current rates. Nothing typed here is stored or sent anywhere.