Interest-Only Mortgage
Table of contents
Interest-only mortgages provide a financing option where borrowers initially make payments that cover only the interest on their mortgage. Typically available for short or medium mortgage terms, this approach can result in significantly lower monthly payments during the interest-only period. However, once the initial term ends, your payments could increase substantially as borrowers repay the principal, making an interest-only mortgage a higher-risk choice for some.
In Canada, alternative mortgage lenders, such as credit unions or private lenders, usually offer interest-only mortgages rather than traditional banks. This financing arrangement may appeal to those looking for temporary financial flexibility, such as real estate investors or homeowners planning significant renovations. Despite the initially lower carrying costs, knowing the potential financial challenges when the principal repayment begins is essential.
Key Takeaways
- Interest-only mortgages allow you to make lower payments by deferring principal repayment for a set term.
- These mortgages are primarily offered by alternative lenders and require a down payment of at least 20%.
- Once the interest-only period ends, payments could increase significantly as borrowers begin repaying the principal.
What Is an Interest-Only Mortgage in Canada?
An interest-only mortgage is a unique financing option that allows borrowers to pay only the interest on their home loan for a set term, usually between 1 and 7 years. During this period, monthly payments are lower since the borrower is not repaying the principal balance. After the interest-only term ends, borrowers must begin paying both principal and interest, leading to significantly higher monthly payments.
Interest-only mortgages can provide short-term financial relief but come with substantial risks, particularly for those unprepared for the increase in payments after the interest-only period ends. In Canada, interest-only mortgages are typically available through alternative lenders like credit unions, B-lenders, and private lenders, as traditional financial institutions and banks generally do not offer them as term loans.
Interest-only mortgages often appeal to home buyers who want lower monthly payments for a short period, perhaps while they renovate or invest in other ventures. A minimum of 20% downpayment is required, saving homebuyers and investors the additional costs of insurance premiums. They can also appeal to real estate investors, allowing them to write off their interest-carrying costs against their rental income over a more extended period without reducing their principal mortgage balance.
How Does an Interest-Only Mortgage Work?
In an interest-only mortgage, the borrower makes payments that cover just the interest for a set period. After the interest-only term ends, you must either pay off your mortgage, refinance it, or begin making significantly higher payments, as now you’ll need to cover both principal and interest.
For example, if you have a $400,000 mortgage at a 6% interest rate and opt for an interest-only mortgage, your monthly payment during the interest-only period would be $2,000. After the interest-only term ends, your payments will rise as you will be required to repay the principal.
Calculated as: ($400,000 x 0.06) /12 months = $2,000
Borrowers must consider managing the increased payments after the interest-only period. They must also evaluate potential risks like declining home values, which could leave homeowners owing more than the property is worth, or rising interest rates, making future payments less affordable.
Pros of an Interest-Only Mortgage
Lower initial monthly payments: Since borrowers only pay the interest during the initial term, monthly mortgage payments are lower, allowing borrowers to use extra cash for other investments or immediate financial needs.
Increased flexibility: Interest-only mortgages provide flexibility for those with fluctuating incomes or who expect their financial situation to improve. These financing arrangements can also benefit self-employed individuals, business owners, or investors expecting significant future earnings.
Potential investment opportunities: The lower payments may free up capital that can be invested elsewhere, such as in-home renovations that can increase the property’s value or other ventures that generate higher returns.
Lower taxable income: If the mortgage is used to finance an investment property or business, then interest-carrying costs can be written off against the income generated from the property or business. As the principal is not paid down, the interest-carrying costs to reduce the taxable income will remain elevated for a longer term.
Cons of an Interest-Only Mortgage
Payment shock: Once the interest-only period ends, borrowers can face a significant increase in their monthly payments, known as payment shock. They must repay the principal and interest based on their selected amortization period. These increased carrying costs could create financial strain, especially for those not adequately prepared for the higher payments.
Reduced equity growth: During the interest-only period, borrowers do not build home equity through mortgage payments, as no principal is being repaid. This poses a risky venture if home prices decline or the borrower needs to sell the property.
Higher long-term costs: While initial payments are lower, interest-only mortgages can be more expensive in the long term. Since the principal is not being reduced during its interest-only phase, borrowers will ultimately pay more interest over the life of the home loan.
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Who Should Consider an Interest-Only Mortgage?
An interest-only mortgage may be ideal for individuals in specific financial situations, such as:
Investors or house-flippers: Those purchasing a property to renovate and sell quickly may benefit from lower monthly payments before selling the home for a profit.
Individuals with variable income: Borrowers with irregular income, such as freelancers or business owners, may prefer the flexibility of paying lower amounts during periods of financial uncertainty.
Individuals expecting higher future income: Those anticipating a significant increase in income may find an interest-only mortgage manageable, as they can handle the higher payments later when principal repayments are due.
Alternatives to Interest-Only Mortgages
While interest-only mortgages may seem attractive, several alternatives may better suit some borrowers:
Choosing a longer amortization period: By extending the amortization period, borrowers can reduce monthly payments while still paying down both principal and interest. Financing over 30 years of amortization may lead to more interest paid over time but avoids the abrupt increase in payments seen with interest-only mortgages.
Making a larger downpayment: A larger downpayment adds to your home equity and reduces the required mortgage amount, which can lower monthly payments and interest costs over the amortization.
Buying a less expensive home: Instead of an interest-only mortgage, borrowers might consider purchasing a lower-priced home with more affordable monthly payments. This strategy can reduce long-term debt and make it easier to manage mortgage payments.
Choosing a Home Equity Line of Credit (HELOC): A HELOC is an interest-only revolving credit facility that can be set up within a collateral charge mortgage registration. HELOCs do not have limits on repayments or set terms when their interest-only phase ends. HELOCs within a collateral charge allow you to switch a portion of the outstanding loan balance into a term loan anytime to start making principal payments over a set amortization schedule on that portion of your balance.
Frequently Asked Questions (FAQs) on Interest-Only Mortgages
How much can I borrow with an interest-only mortgage?
Interest-only mortgages generally require a downpayment of at least 20%, as they do not qualify for mortgage insurance in Canada. Mortgage lenders typically allow you to borrow up to 80% of the home’s value, but this depends on the lender and your financial risk profile.
What happens when the interest-only period ends?
After the interest-only period ends, borrowers must repay the principal and interest, leading to significantly higher monthly payments. At this point, borrowers may refinance, sell the property, or convert the loan to a traditional mortgage.
Are interest-only mortgages easy to get?
Traditional financial institutions or banks do not typically offer interest-only mortgages, primarily available through alternative lenders. While these mortgages may be easier to qualify for than conventional loans, they come with higher risks and costs. Traditional banks will finance HELOCs, which function similarly to interest-only mortgages without limitations on terms or repayments.
Can I build equity with an interest-only mortgage?
You can still build equity in your home through appreciation in its market value. However, you do not increase your equity through monthly payments, as no principal is repaid during the interest-only period.
Are interest-only mortgages insured?
No, interest-only mortgages do not meet the criteria for mortgage default insurance, as they do not reduce the principal. Borrowers must make a downpayment of at least 20% and work with alternative lenders. However, if you paid down your high ratio mortgage under a collateral charge, you could readvance the limit as a HELOC, which functions similarly to an interest-only mortgage.
Final Thoughts
Interest-only mortgages can provide short-term financial relief with lower payments, making them an attractive option for some borrowers. However, they come with considerable risks, including significantly higher payments after the interest-only term and the lack of equity growth during the initial period. Before choosing this option, it’s essential to understand the benefits and risks and explore alternatives, such as those offered by taking on more extended amortization periods, setting up a HELOC, or making larger downpayments. Reach out to nesto mortgage experts to see if an interest-only mortgage is a suitable solution for your financial circumstances and mortgage strategy.
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