What is an 'interest-only mortgage'?

An interest-only mortgage is a specific type of loan in which the borrower is responsible for paying only the interest for a predetermined period of time, which is typically several years. During this interest-only phase, the principal balance of the loan remains unchanged because no payments are made towards it. After this initial period expires, the borrower begins to make payments that cover both interest and a portion of the principal, which can lead to significantly higher payments once the repayment period starts.

This structure allows for lower initial monthly payments, which can be appealing for borrowers who may expect to have greater income in the future or plan to refinance before the interest-only period ends. Understanding this concept is crucial as it impacts cash flow and financial planning, particularly in relation to potential changes in income and market conditions.

The other answer choices do not accurately describe the characteristics of an interest-only mortgage, as they either imply different payment structures or do not consider the mechanism whereby the borrower transitions to repaying the principal after the interest-only period.