Interest Only Loan

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An interest only loan is a where a borrower only pays the interest on the loan for a fixed period of time.

What is an interest only loan?

An interest-only loan or mortgage is a type of loan that requires you to pay only the interest costs without paying the original principal. Once the interest-only period ends, you will begin making the principal payments.

How does an interest only loan work?

Let’s say you take out a $300,000 30-year traditional mortgage at a 5% interest rate. Excluding property tax, property insurance, and private mortgage insurance, your monthly payment would be $1,610.46.

On the other hand, if you took out a $300,000 30-year interest-only mortgage, with a 10-year interest-only period at a 5% interest rate, your monthly payment would be $1,250. After 10 years, your payment would increase to $1,979.87 to include the principal and interest payment. At this point, your loan is now an amortizing loan. In other words, you are currently paying down your debt.

The most important take away is that during those 10 years, you would save $360.46 per month. However, of course, you always have the option of paying more toward the principal debt during this time as well.

Advantages of Interest Only Loans

What makes interest-only loans so attractive is that you can afford your home sooner. During the interest-only time, the monthly payments are significantly lower. As a result, this type of mortgage is ideal for borrowers who know that their home will be sold within a short period of time or are confident that they will be able to afford the more substantial payment in the future.

With lower monthly payments, you can afford a more expensive property. Lenders look at your debt-to-income ratio. A traditional mortgage payment would qualify you for a smaller loan. However, an interest-only loan qualifies you for a more substantial loan amount because the smaller monthly installment is more affordable.

Furthermore, with a lower monthly payment, you free up cash flow. You can now choose to invest your money elsewhere instead of tying it up in your mortgage. Investing the funds is advantageous if you can get a higher rate of return.

Disadvantages of Interest Only Loans

Interest-only mortgages seem extremely attractive, at least for the initial period of time. Unfortunately, lenders usually charge a half percent of a point more of interest than on conventional loans. For instance, if a traditional 30-year fixed mortgage has a market interest rate of 4.5%, the interest rate on an interest-only loan may be 5%. Don’t forget to shop around as lenders vary.

There are inherent risks that come with interest-only mortgages. If your income does not grow as expected, you may not be able to afford the new payments when the interest-only period is up.

By paying the interest first, you are not building equity in your home during this time.

Finally, interest-only loans increase your risk of being “upside-down” or “underwater.” These terms refer to owing more money on your home than you can sell it for. This happens if your home loses value after you buy it. If your home sells for less than what you owe, you will end up writing a check to pay the difference.