Due to the rising price of homes in Canada and the mortgage stress test, it has been challenging for Canadians to secure a mortgage. If you’re frustrated by the housing economy – you’re definitely not alone.
For these reasons, some Canadians are turning to alternative mortgages to purchase a home successfully. One variation of a traditional mortgage is an interest-only mortgage. To learn more about an interest-only mortgage, and how it differs from traditional mortgages. and the pros and cons, continue reading below.
Key Points
- Interest-only mortgages let you pay only the interest portion of your loan over a specific term.
- With an interest-only mortgage, you can enjoy lower monthly mortgage payments during the term.
- Generally speaking, only alternative lenders offer interest-only mortgages, as they are not widely available from prime lenders.
What Is An Interest-Only Mortgage?
As the name implies, an interest-only mortgage is a type of mortgage financing in which your monthly payments only include interest. There is no principal repayment with an interest-only mortgage. The only way the principal balance will change is if you make extra payments.
Keep in mind that interest-only mortgages are usually structured with the option to make interest-only payments. You could make regular payments with the principal included and exercise your interest-only option when you face financial struggles.
The term of an interest-only mortgage is fixed and typically lasts between five and seven years. Once the term is up, most borrowers refinance their mortgage, begin to pay the principal of the loan or make a lump sum payment.
What Happens After The Interest-Only Term Ends?
Once the interest-only mortgage term ends, you have a few options:
Start Repaying Your Principal
You’ll need to start making payments towards the principal for the rest of the mortgage amortization period. Make sure you have a clear idea of how much these payments will be beforehand to ensure you budget accordingly.
Refinance
You can choose to refinance your mortgage after the interest-only term ends. This will allow you to secure a lower interest rate (if possible) and make changes to your terms if the timing makes sense.
Sell Your Home
If you have plans to sell soon or want to capitalize on your home’s appreciation, you may choose to sell your home to pay off your mortgage. Just make sure to consider any early prepayment penalty fees that may apply if you break your mortgage before the end of the term, as these can add up to thousands of dollars.
Traditional Mortgage Vs. Interest-Only Mortgage
An interest-only mortgage is still a mortgage and shares many characteristics of traditional mortgages. However, there are some notable differences between the two as well:
- Avoid Immediate Burden Of Traditional Mortgage. An interest-only mortgage allows you to ease into the financial obligation of homeownership and mortgages. With a traditional mortgage, it all comes at you at once.
- Principal Repayment Timing. Both a traditional and interest-only mortgage requires you to repay the principal. The difference is timing: whereas a traditional mortgage involves immediate principal repayment, an interest-only mortgage involves delayed principal repayment.
Requirements To Qualify For An Interest-Only Mortgage
What are the loan requirements for interest-only mortgages? Are there upfront payments to make, or tests to undergo?
Do You Need A Down Payment?
Interest-only mortgages don’t meet the criteria of mortgage default insurance providers, like CMHC, since these loans don’t pay down the principal and don’t amortize. As such, you can’t insure an interest-only mortgage. That means you’ll need to make a down payment of at least 20% on this type of mortgage.
Do You Need To Pass The Stress Test Requirement?
The mortgage stress test is required for mortgages provided by prime lenders. However, prime lenders don’t offer interest-only loans, so you’ll need to apply with a private lender for this type of mortgage.
Private lenders generally don’t require a borrower to pass the mortgage stress test, since these lenders are not federally-regulated. As such, they have more flexibility with the loan criteria they require borrowers to meet. This includes the stress test.
As such, you likely won’t need to undergo the mortgage stress test with this type of mortgage.
Pros And Cons Of An Interest-Only Mortgage
Before making your decision to proceed with an interest-only mortgage, it’s important to consider the advantages and disadvantages to ensure that the choice suits your personal financial situation best:
Pros
- Low initial monthly payments. The biggest perk of an interest-only mortgage is that monthly payments are low during the beginning of the mortgage term. This can make these home loans more affordable at first.
- Extra money can be used elsewhere. The extra cash that isn’t being put toward the principal amount of the mortgage can be used for other purposes, including boosting cash flow, investing, or paying off other high-interest bills.
- Interest may be tax deductible. If you use part of your home to rent out or to use as an office for self-employment, you may be able to deduct the mortgage interest when you file your income taxes. Keep in mind that you can’t deduct mortgage interest payments on principal homes in Canada. Tax deductions on mortgage interest only apply in cases where your home is being used to earn income from rent or self-employment, as mentioned.
Cons
- Slower growth in equity. Since you’re not making any payments towards the principal, you’re not contributing to equity growth in your home.
- Payments will increase. When the time comes to make principal payments, you could find yourself unable to afford them, since payment amounts typically increase significantly following the interest-only period.
Where Can I Get An Interest-Only Mortgage?
Federally-regulated lenders, like banks and some credit unions, will not offer interest-only mortgages, even with a down payment of 20% or higher. As such, you’ll need to apply for an interest-only mortgage with an alternative lender. These include ‘B’ lenders, private lenders, and some non-federally regulated credit unions.
Under Guideline B-20, lenders governed by this regulation must establish a residential mortgage underwriting policy (RMUP).
Under this policy, lenders must set the maximum amortization period for the mortgages they provide. As such, only alternative mortgage lenders can offer interest-only mortgages.
Other Interest-Only Loan Products
That said, some banks offer loan products using your home equity that may allow you to make interest-only payments for a time, such as the following:
| RBC Homeline Plan | The RBC Homeline Plan is a combination of a mortgage and home equity line. With this plan, you must make interest payments each month, but payments toward the principal are not required for a certain amount of time. |
| Scotiabank Progress Draw Construction Mortgage | This product is designed for homeowners who need extra money to make renovations to their homes. This plan lets you finance your construction project with an 18-month mortgage with interest-only payments. |
| CIBC Home Power Plan Line Of Credit | This is a home equity credit line that is collateralized by your home equity. It allows you to borrow from your equity, with the option to make interest-only payments for a time. |
| TD Home Equity FlexLine | The TD Home Equity FlexLine product allows you to access credit from your home equity on a revolving basis. As you pay down the balance, your available credit increases up to a specific credit limit. |
Alternatives To Interest-Only Mortgages
If you’re considering an interest-only mortgage as a way to keep your mortgage payments low, there are some alternatives to consider:
Opt For A Longer Amortization
Extending your amortization will allow you to spread out your payments over a longer period, therefore lowering each installment you make. While this means more interest paid over the life of the loan, it’s a way to keep your mortgage payments within a more affordable range.
Make A Bigger Down Payment
If you have the financial resources, consider putting as much money as you can upfront to make a larger down payment. This will reduce the amount you have to borrow, and therefore lower your mortgage payments.
Buy A Cheaper Home
Even if you qualify for a high loan amount to buy a more expensive home, consider borrowing less and buying a home in a lower price range. Again, the less you borrow, the lower your mortgage payments will be. Plus, it may be easier to get approved for a lower mortgage amount at a more affordable interest rate.
Who Should Consider An Interest-Only Mortgage?
Interest-only mortgages have a unique structure that is only favourable in some circumstances. Below is a list of scenarios where an interest-only mortgage is desirable:
- You’re purchasing and selling the property in a short period.
- You can afford a large payment increase in the future in exchange for a lower payment now.
- You don’t earn a flat salary and have a variable salary instead.
- You’re able to earn more with your money elsewhere in the short term.
- You’re a first-time home buyer who is not accustomed to making mortgage payments and covering other homeownership costs.
Bottom Line
Before deciding to use an interest-only mortgage, be sure to consider the risks as well as the perks. While you may be able to free up more cash over the initial months by avoiding principal payments, these payments will eventually need to be made. It’s also important to keep in mind that you’re not contributing to your home equity if you’re not making any principal payments. These are key considerations to make before opting for an interest-only mortgage.
