What is an interest-only mortgage?

Tim Bennett
by Tim Bennett September 7, 2020 / No Comments

The Canadian mortgage market has a wide variety of products for prospective homebuyers. While most people opt for mainstream mortgages with normal terms, there are more niche products available, such as interest-only mortgages.

But what is an interest-only mortgage, and are they ever a good idea? Here’s everything you need to know about interest-only mortgages in Canada.

What are interest-only mortgages?

Interest-only mortgages are just like normal mortgages, except that your regular payments only pay off the amount of interest that has accrued. Traditional mortgages require you to pay this in addition to making a payment against the principal of your mortgage, the amount you actually borrowed.

As a result, the regular payments for interest-only mortgages are lower than they would be for a comparable traditional mortgage. However, they will cost you more in the long run – more on that below.

Interest-only mortgages are a niche product, with only a few legitimate use cases. If a borrower has very sporadic income, an interest-only mortgage may let them buy a home with lower regular payments when their income is low, but pay off a large lump-sum of the principal when income is plentiful. Another use case might be someone who is looking to make a short term investment in real estate, though this is a risky practice.

For most Canadian homebuyers, interest-only mortgages are a bad idea. This is because they are generally riskier and more expensive than traditional mortgages.

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Are interest-only mortgages riskier than normal mortgages?

Interest-only mortgages carry more risk than traditional mortgages because they don’t result in you gaining more equity in your home. With every payment on a traditional mortgage, you’re owning more and more of the property yourself, as opposed to it being owned with borrowed money. That’s not the case with interest-only mortgages.

If for some reason you need to sell your home and pay off your mortgage, having equity is important. With little or no equity in the home, you’ll be relying on the price of your home to have increased to cover the outstanding mortgage. More home equity gives you a larger buffer, making it more likely you’ll be able to pay back your mortgage in full.

As a result of this additional risk, interest-only mortgages are generally only offered by alternative lenders, such as private mortgage providers or trust companies.

Why interest-only mortgages are more expensive

There are two main reasons why an interest-only mortgage will cost more than a traditional mortgage; additional interest payments, and higher mortgage rates.

Additional interest payments: With an interest-only mortgage, you’ll initially only pay interest, without paying off any of the principal. Any interest you pay during this period will be additional to what you’d pay on a traditional mortgage. For example, if you made interest-only payments of $2,000 a month for the first year, your overall mortgage would cost you around $24,000 more than if you had been paying off the principal from the beginning.

Higher interest rates: Interest-only mortgages aren’t just more risky for you, they’re risky for your mortgage provider as well. The last thing your lender wants is for you to default on your mortgage, but that’s more likely to happen to borrowers with interest-only mortgages. As a result, lenders set higher rates for interest-only mortgages. This can cost you a lot more over time, even if your interest-only payments are temporary.

Should I get an interest-only mortgage?

There aren’t many situations that call for an interest-only mortgage, so a good rule of thumb is to avoid them at all costs. While the prospect of lower monthly payments might seem appealing if your cash flow is limited, it’s not worth the additional cost.

If you’re looking at an interest-only mortgage as an option for a geared property investment, then know that it’s an incredibly risky venture. There are probably better, less risky ways to make money.

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Alternatives to an interest-only mortgage

If you’re considering an interest-only mortgage because of the lower monthly payments they offer, here are a few other options you might want to consider.

Saving a larger down payment: A larger down payment means a smaller mortgage, which means lower monthly payments. You might consider renting or living with your parents for a while longer, focusing on your savings, then buying a house in a year or two.

Taking out a longer mortgage: A mortgage with a longer amortization period (the total life of the mortgage) will have lower monthly payments. If your down payment is less than 20%, you’ll be limited to a maximum of 25 years. However, if you have a down payment of 20% or more, your amortization period can be up to 30 years.

Buy a cheaper home: Whether it means looking at a condo, a smaller house, or a different location, a cheaper home will mean you can get a smaller mortgage. This will result in lower monthly payments and might help you pay your mortgage off sooner. Remember that you can always move home if your financial situation changes.

The bottom line

An interest-only mortgage is almost always a bad idea for most Canadians. However, it’s a niche product that sometimes has a place. If you’re seriously thinking about getting an interest-only mortgage, it might be a good idea to speak to a mortgage broker about your options. Consultations with brokers are free and are a great way to get expert advice on your personal circumstances.

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