What is an interest-only mortgage? How does it work?

An interest-only mortgage is a type of home loan where the borrower is only required to pay the interest on the loan for a specified period. During this initial period, the borrower is not required to make any payments towards the loan of the house, just the interest.

After the interest-only period ends the loan converts into a traditional amortizing mortgage, where both principal and interest payments are made, and the loan balance is gradually paid down over the remaining loan term.

Here’s how an interest-only mortgage works

During the interest-only period, the borrower makes monthly payments that cover only the interest portion of the loan. As a result, these payments are typically lower than what they would be for a traditional fixed-rate mortgage where both principal and interest are repaid.

At the end of the interest-only period, the loan converts to a traditional mortgage, and the borrower must start making payments that cover both the principal and interest.

The negatives

Interest-only mortgages are generally riskier than traditional fixed-rate or adjustable-rate mortgages. The loan needs to be fully-paid off by the time the interest-only period ends. Once this period ends, you’ll need to pay it back or remortgage your home.

Banks will likely request to see evidence that you can fully pay the loan in full, called a ‘repayment vehicle’ such as savings or investments. This works as a guarantee.

There’s no equity buildup during the interest-only period, so homeowners won’t see their home equity grow until the principal payments begin. This is coupled with the problem of only interest being paid, so thefull amount is still owed at the end of the term.