As Canadian borrowers continue to navigate fluctuating interest rates and rising housing costs, alternative financing options like interest-only mortgages can offer lower upfront monthly payments, which may help free up cash flow. This type of alternative financing may appeal to borrowers looking for temporary financial flexibility. 

However, this borrowing solution is usually only offered through alternative mortgage lenders like credit unions or private lenders. Once the initial interest-only term ends, mortgage payments could significantly increase to repay the principal. This guide explores how interest-only mortgages work in Canada, including the pros and cons, who qualifies, and the alternatives available.

Key Takeaways

• Interest-only mortgages allow you to pay only the interest portion of your mortgage for a set period.
• Monthly payments are initially lower, but the principal remains untouched, leading to higher payments later.
• Interest-only mortgages are typically only offered by alternative and private lenders.

What Is an Interest-Only Mortgage?

An interest-only mortgage is a loan option in which the borrower pays only the interest for a set term, usually between 1 and 7 years. During the interest-only period, monthly mortgage payments are lower because no principal is being repaid.

After the interest-only period ends, the borrower begins to repay the principal and interest, leading to significantly higher monthly payments. Due to this, these types of mortgages come with substantial risks, especially for borrowers not prepared for their payments to increase when the interest-only payments end. 

These types of mortgages often appeal to borrowers who want lower monthly payments over a short timeline, for example, to renovate or invest. They also appeal to investors since they can write off the interest costs against rental income. In Canada, these mortgages are typically only available through alternative lenders and require a minimum 20% down payment.  

How It Works

Interest-only mortgages require payments that only cover the interest portion of the loan for a set term. Once the interest-only term ends, borrowers must pay off the mortgage in full, refinance, or make significantly higher payments to cover the principal and interest. 

For example, if you have a $500,000 mortgage with a 6% interest rate, your monthly payments on an interest-only mortgage would be $2,500 compared to approximately $3,199 for a mortgage that covers principal and interest payments over a 25-year amortization. 

However, since an interest-only mortgage leaves your principal unpaid, your payments will increase after the interest-only term ends to account for the unpaid principal. For example, if you had an interest-only mortgage for a 5-year term, you would have only paid interest on $500,000 for 5 years. You still owe $500,000, so your new payments will include this balance in your calculation, leading to much higher monthly payments. 

Benefits of an Interest-Only Mortgage

For some borrowers, the benefits of an interest-only mortgage with lower monthly payments and increased flexibility can offset some of the long-term costs of this borrowing solution. Some of the benefits of an interest-only mortgage include:

Lower Payments: Lower payments during the interest-only term can help free up funds. You can use the additional cash for investments or immediate financial needs. 

Lower Taxable Income: If you use the property as an investment, the interest costs can be written off against the income generated, reducing your taxable income. Since you don’t pay down any principal over the term, you will have more interest-carrying costs associated with the loan, which can be used to reduce taxable income.

Ideal for Short-Term Ownership or Flipping: If you plan to sell the property before the interest-only term ends, you may never have to repay the principal.

Drawbacks of an Interest-Only Mortgage

This type of mortgage isn’t for everyone. The trade-off for short-term savings can lead to significant expenses in the long run. Some of the drawbacks of interest-only mortgages include:

No or Reduced Equity: You won’t build equity by paying the principal during the interest-only repayment period. This means you will only build equity if the property appreciates in value greater than what you paid. This makes interest-only mortgages risky if property values decline or you need to sell the property before it has time to appreciate. 

Higher Payments After the Interest-Only Period: When the interest-only payment period ends, payments can increase considerably since you haven’t paid down any principal. This also means you pay more interest over the life of the loan. 

Payment Shock: Based on the selected amortization period, borrowers could face payment shock once the interest-only term ends as payments increase considerably to cover principal and interest. The sudden increase in carrying costs could cause financial strain if you’re unprepared for higher payments. 

Who Should Consider an Interest-Only Mortgage?

Interest-only mortgages work best for borrowers with a well-structured financial plan or who can weather significant financial changes. These include:

• Real estate flippers who plan to renovate and resell quickly, typically within the interest-only period.
• Real estate investors planning to rent the property can write off the interest against taxable income.
• Individuals with variable incomes who prefer the flexibility of lower payments during periods of irregular income. It is best reserved for those with significant cash reserves or who expect higher future income to make larger repayments later. 

Alternative Options to Consider

Several alternatives to interest-only mortgages may be better depending on your needs and financial situation. 

Home Equity Line of Credit (HELOC): A HELOC is a revolving credit facility that can be set up as a collateral charge registration. Repayments are not limited, and there are no set terms, allowing you to switch a portion of the outstanding loan balance into a term loan at any time.

Extend the Amortization: With prime lending, you can reduce mortgage payments by extending the amortization, typically up to 30 years. While this leads to more interest paid over the life of the loan, it can help you make payments more manageable while reducing the shock of a significant payment increase with an interest-only mortgage. 

Make a Larger Down Payment: Putting down more toward the purchase price increases your equity in the property from the start. A larger down payment reduces the mortgage amount, resulting in lower payments and interest paid.

Frequently Asked Questions

Final Thoughts 

Interest-only mortgages can offer short-term affordability and strategic benefits, especially for investors or those with unique financial needs. However, they require careful planning to avoid payment shocks and long-term debt risks. 

Ready to explore your mortgage options? Contact a mortgage professional today.