It’s safe to say that when the federal government introduced its mortgage stress test at the start of 2018, it threw a wrench into the homebuying plans of a lot of Canadians.
But while many people were suddenly finding themselves unable to make the cut, a new market was also emerging to cater to their newfound needs. From alternative lenders that aren’t subject to federal regulations to startups that contribute to your down payment in exchange for a share in your home, a crop of new businesses and products are hoping to sidestep traditional — and increasingly inaccessible — routes to home financing, and working to redefine what it looks like to pay for a home.
One notable product is not actually new, but in these tough times, it’s going through something of a revival. Interest-only mortgages are exactly what they sound like: mortgages that only require you to make interest payments for a set period — typically a few years — before tackling the principal. While one benefit of this arrangement is clear — it allows you to buy a home without the immediate financial burden of a traditional mortgage — interest-only mortgages also come with their share of baggage, and hold a pretty controversial reputation among brokers across Canada.
Still, every homebuyer is unique, and contrary to popular belief, there are situations where interest-only mortgages are the best course of action. To find out what they are, and to learn more about how interest-only mortgages work, we talked to Nalie Nguyen, executive director of Dash Mortgage.
How are interest-only mortgages different?
Like a regular mortgage, an interest-only mortgage is a loan that’s meant to cover the part of your home purchase you couldn’t pay for out of pocket. The difference between the two products is how you pay your lender back: whereas a regular mortgage requires you to make regular payments towards your principal, onto which you’d add interest, an interest-only mortgage only requires you to pay interest — at least for a while.
Because of course, you can’t just pay interest forever: your lender will eventually want the principal back. The interest-only part of the payment plan only lasts for a set period, and then you’re required to start paying off the principal — and more interest. Yes, you read that correctly. With an interest-only mortgage, you almost always end up paying the lender back more than you would with a regular mortgage, both because you’re typically making more interest payments, and because the interest rates are “definitely higher,” according to Nguyen.
As with a regular mortgage, the specific payment terms of an interest-only mortgage will vary depending on your lender. But because this product is only offered by alternative lenders, not banks (which are federally regulated), those terms could vary a lot depending on whom you’re talking to. Some lenders might stress test you, even if they’re not legally required to; some might give you the option to accelerate your payments with a minimal penalty.
“They don’t have to follow the normal mortgage rules,” Nguyen says.
Who would benefit from one?
So far, an interest-only mortgage doesn’t sound like the best deal. And for most people, says Nguyen, it isn’t.
The clientele for this type of mortgage is typically people who haven’t been able to secure a mortgage through a traditional lender — generally because they haven’t been able to pass the stress test. And because lenders of interest-only mortgages know their typical customer can’t get a better deal, they can get away with marking up their prices. “They have to pay quite a high interest rate,” says Nguyen, “Because it’s a niche product.”
So, are there any situations where an interest-only mortgage is a smart choice?
It depends on how you use them. Since they’re less of a financial burden that a regular mortgage — at least when you’re only making interest payments — you’ll have more cash available to accelerate your other debt payments (especially lines of credit with higher interest rates), or to save.
Let’s compare an interest-only $500,000 mortgage, and a fixed-rate $500,000 mortgage. Say their terms are the same: 25-year amortization, at 2.54% interest. (Keep in mind, however, that you’ll be hard-pressed to find an interest-only mortgage with a rate this low.) Your monthly payments for a regular mortgage with a five-year term would be $2,249.80. However, if you were only paying the interest on this payment, you’d be paying $1,038.82 a month in the first year of the term. That’s a difference of $1,210.98.
The difference is, in a word, huge. However appealing that extra cash flow looks, though, remember that if you’re only just able to keep up with your interest-only payments to begin with, you should not be considering an interest-only mortgage. Otherwise, you’ll find yourself in a financial emergency when it comes time to start paying off your principal, too.
Nguyen says another important factor to consider is the market you’re buying in.
“If you’re telling me you’re buying in Calgary where the market is not that great, I would say just rent for a while until you can qualify for a mortgage,” she says. “But if you are living in the Toronto area where property values are going up drastically, and you don’t want to miss out on the purchasing opportunity, then maybe it’s not a bad option to go with private lender even though the rate is slightly higher.”
At the end of the day, it’s important to do careful research and to be honest about what you can afford, because the interest-only option is a risky one.
“For most Canadians, I don’t think it’s the best product,” Nguyen says.