What Is an Interest-Only Mortgage in Canada?

This is a vintage type of mortage not seen in years. Lenders took a hiatus from offering interest-only mortgages in 2010. Depending on your situation, interest-only mortgages could be beneficial or a detriment to your finances. Choosing a mortgage in Canada is a personal decision and will look different for everyone depending on your financial situation. Use a mortgage calculator to estimate your monthly payments before determining if an interest-only mortgage is right for you.

Interest-only mortgages compared to traditional mortgages

Interest-only mortgages are not very common. Your monthly mortgage payments only go towards paying off the interest from your mortgage, not the principal amount. The principal, the overall amount you have borrowed from your lender, stays the same throughout your term. Any monthly payments go towards only the amount of monthly interest accrued. 

Not paying off the principal means that your monthly payments will be low. However, you will still have the same lump sum of money owing at the end of your term. This is significantly different from a traditional mortgage. In a typical mortgage agreement, you slowly pay off the interest and a portion of your mortgage principal each month. The payments made to your principal will add up over time. At the end of the mortgage, everything is paid off.

Read more about different types of mortgages

How do interest-only mortgages work?

Interest-only mortgages are not a long-term solution. The closed term means you cannot make any payments on your principal during the term. You cannot pay off your mortgage early. With the fixed rate, your interest rate is locked in, so your monthly payments won’t change over your term. When your interest-only agreement is over, you can refinance into a traditional mortgage or pay off your principal completely. Paying off your whole mortgage in a lump sum isn’t always realistic. That is why refinancing for a longer term is typically the way to go. 

To qualify for an interest-only mortgage, you typically need a 20% down payment on your principal, and you to pass a mortgage stress test. The stress test is standard for every home buyer in Canada, no matter your choice of mortgage product. The stress test determines your ability to keep up with mortgage payments, even if interest rates increase significantly.

Who could benefit from interest-only mortgages?

On closer inspection, interest-only mortgages may not sound all that appealing. For many Canadians, making monthly payments only to be saddled with a considerable principal to repay at the end of their term is not feasible. That being said, there may be some cases where interest-only mortgages could be a good option.

If your income fluctuates from year to year, you may benefit from lower monthly payments with an interest-only mortgage. During periods with less income, you won’t have to worry about having a high monthly mortgage payment. When you have more income, you can save or invest funds to put towards your principal later. You can save with a high-interest savings account if you want less risk than investing and with a slightly better interest rate than a traditional savings account.

This offering may also benefit new parents who need to take time off work to care for a new baby. Entering an interest-only mortgage term for a couple of years may help new parents pay for child expenses and make up for their change in income. After a few years of lower payments, they can re-enter a traditional mortgage once they have had time to adjust.

If you plan on selling your house soon after purchase, an interest-only mortgage could be convenient as long as your house doesn’t decline in value. If your home does depreciate, you will still be on the hook for whatever is remaining on your mortgage principal.

Risky business

Although interest-only terms are still risky and typically not the best choice for a mortgage. Saving for a larger lump sum payment during the term ensures you don’t land yourself in a rough financial spot.

Unfortunately, saving is often easier said than done. If you don’t have a plan for how you will eventually pay off your principal, or if you know you have difficulty saving money, a traditional mortgage will probably be a better choice for you. If you’re worried about finding the right mortgage for your situation, using a mortgage comparison tool can help you better understand your options.

What are the risks associated with interest-only mortgages?

There are many risks associated with interest-only mortgages. Some financial experts even attribute interest-only mortgages and similar “flexible” mortgage offerings to the past mortgage crisis in the US. Although interest-only mortgages might seem like a good idea on paper, the truth is that life is unpredictable. If you enter into an interest-only mortgage because you expect to make more money in the coming years, but your plan doesn’t work out, you could be on the hook for a large amount of money you cannot repay. Defaulting on your mortgage could mean losing your home.

If you choose a more traditional mortgage after your interest-only term, you may find yourself unprepared and unable to keep up with the higher monthly payments you thought you could afford. Mortgage calculators could help you avoid this outcome.

Over time, an interest-only mortgage will be significantly more expensive than a traditional one. For example, if your interest-only payments were $1000 a month for one year, the overall cost of your mortgage would be $12,000 more than if you had been paying off your principal from the start. You are essentially “renting” from your mortgage with this plan, as you are receiving none of the equity a traditional mortgage affords. 

Interest-only mortgages: The Takeaways

While interest-only mortgages may be useful in some situations, they are typically not the best choice for your mortgage needs. Many banks have flexible offerings that grant you more security and equity than an interest-only mortgage. Suppose you know you will be able to pay off your mortgage principal in the future. In that case, having a lower monthly payment could free up some funds for investing or emergencies. Still, for most of us wondering how to choose a mortgage in Canada, interest-only mortgages are something to avoid.