You should think twice before taking out an interest-only mortgage — here's why

With mortgage rates higher than they have been in over two decades, homebuyers may be looking for alternative ways to finance their home.

An interest-only mortgage can free up some front-end cash, allowing a buyer to cheaply purchase otherwise expensive property, but it carries long-term risks that borrowers should seriously consider. 

Here, CNBC Select shares everything you need to know about interest-only mortgages, including how they work and their benefits and risks.

• What is an interest-only mortgage?
• How to calculate an interest-only mortgage payment
• Benefits of an interest-only mortgage
• Risks of an interest-only mortgage
• Bottom line

In a traditional loan, borrowers gradually repay the principal (the money borrowed) and the interest (the amount it costs to borrow that money). 

This is slightly different in an interest-only mortgage. After a borrower takes out an interest-only loan, they are allotted an introductory grace period, during which they do not have to make payments on the principal of the loan. Instead, they only make interest payments throughout that set period. 

Borrowers must then repay the loan in full, whether by lump sum or gradual monthly payments when that set period is over. 

Interest-only mortgages are primarily designed for borrowers who stand to make a profit from their loan-funded purchase. For example, if you flip houses, you might take out an interest-only loan to purchase a fixer-upper, since you plan to sell the house at a higher price later. By doing so, you postpone your principal payments until you have sold the renovated house, freeing up front-end cash to make said renovations.

Several of CNBC Select's top-ranked mortgage lenders offer interest-only mortgages, including Chase Bank and PNC Bank. 

CNBC Select found PNC Bank to be the best lender for flexible loan options. PNC Bank offers interest-only mortgages to eligible borrowers with a minimum credit score of 620 and a minimum down payment of 3%. Further, the national lender offers a plethora of tailored mortgage options as well as online and in-person application processes. 

Meanwhile, Chase Bank stood out for its flexible down payment options. Similar to most lenders, Chase Bank offers interest-only mortgages to eligible borrowers with a minimum credit score of 620 and a minimum down payment of 3%. Further, the company offers a wide range of mortgage terms and a number of educational resources to support their borrowers through the home-buying process.

To calculate the payment you'll make on an interest-only loan, multiply the loan balance by the annual interest rate, then divide by 12.

For example, say you borrow $100,000 at a 5% interest rate. Your calculation would look like this: (100,000 x .05)/12 = 416.67. This means that your interest-only payment would be $416.78 per month. 

Payments will then increase to those of a typical, amortized loan, covering both principal and interest. Because your new monthly payment amount is based on the remaining principal, the payments should marginally change as you pay off the mortgage. 

The most obvious benefit of an interest-only mortgage is that monthly payments are initially considerably lower than of typical loans. These loans allow the borrower to make larger purchases that they would otherwise only be able to afford a few years down. Thus, interest-only loans might be a wise investment if you are expecting a significant income boost in the coming months and years. 

Interest-only mortgages typically turn into an adjustable-rate mortgage (ARM) once principal payments begin, and borrowers can potentially benefit from a lower rate than the fixed-rate average. 

But in the same vein, that adjustable-rate mortgage might be significantly higher than a fixed-rate traditional mortgage taken out initially, and this is one among many risks associated with interest-only mortgages. 

Though a borrower's monthly payments are initially temporarily lower than those of a traditional loan, there are several considerable risks. 

First, if you take out an interest-only mortgage, you will not gain any equity in your home (beyond the equity of your down payment) until you begin principal payments. 

Home equity is astoundingly important for your financial future. Equity is the money owed to you should you sell or refinance your home in the future. So, if you take out an interest-only mortgage with a five-year grace period, and you move out in five years, you will likely make no money from the sale of your home (unless the market has boomed exponentially since closing). Your interest-only payments will have realistically acted similarly to rent payments.

Alternatively, if the housing market goes down during your interest-only period and you try to sell your house without paying off any of your principal, you may actually owe the bank money at the time of sale. 

Homeowners sometimes take out a home equity line of credit to access cash value tied up in their home's mortgage. If you purchase your home with an interest-only mortgage, there will be less equity, or less cash, to access if you must take out a second mortgage. 

Second, your monthly payments will be relatively high once you begin paying back the principal. This will cause a considerable shift in your monthly budget. Unless you are incredibly financially disciplined, you might not be able to afford these payments. Some interest-only mortgages even require that you pay off the loan in a lump sum when the introductory grace period ends. 

Read the terms of an interest-only loan closely and make a sound plan for the duration of the loan. Otherwise, you might end up stuck in financial mud.

An interest-only mortgage is smart for the forward-thinking borrower who has a sound plan to make future payments. Otherwise, it makes more sense to pursue a traditional mortgage, avoiding the temptation to bite off more than your wallet can chew. 

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every personal finance guide is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of personal finance products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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