Interest only Loan

Interest only loan will be charged for the interest only; therefore if you pay no extra, your loan balance remains the same. Banks determine a specific term, for example, five or 10 years, before it converts to a Principal and Interest Loan which will then need to be paid out in the specified term, usually 25 or 30 years. This is a good safety net for those who get lazy about their debt reduction. There are some great benefits to Interest Only loans.

Who Should Consider An Interest Only Loan?

The borrower may consider an interest only mortgage if they:

• Desire to have more houses now
• Know that the home will need to be sold within a short time period.
• Want the initial payment to be lower and they have the confidence that they can deal with a large payment increase in the future.
• Are fairly certain they can get a significantly higher rate of return investing the money elsewhere.

An interest-only loan is a loan that temporarily allows you to pay only the interest costs, without requiring you to pay down your loan balance. After the interest-only period ends, which is typically five to ten years, you must begin making principal payments to pay off the debt.

Monthly payments for interest-only loans tend to be lower than payments for standard amortizing loans (amortization is the process of paying down debt over time). That’s because standard loans typically include your interest cost plus some portion of your loan balance.

These tools in Google Sheets can help

• Have an interest-only loan calculator do the math for you.
• Compare interest-only payments to fully amortizing loan payments.

Interest-only payments don’t last forever. You can repay the loan balance in several ways:

• At some point, your loan converts to an amortizing loan with higher monthly payments. You pay principal and interest with each payment.
• You make a significant balloon payment at the end of the interest-only period.
• You pay off the loan by refinancing and getting a new loan.

Benefits of Interest-Only Loans

Interest-only mortgages and other loans are appealing because of low monthly payments.

Buy a more expensive property

An interest-only loan allows you to buy a more expensive home than you would be able to afford with a standard fixed-rate mortgage. Lenders calculate how much you can borrow based (in part) on your monthly income, using a debt-to-income ratio. With lower required payments on an interest-only loan, the amount you can borrow increases significantly. If you’re confident that you can afford a more expensive property plus you’re willing and able to take the risk that things won’t go according to plan an interest-only loan makes it possible.

Free up cash flow

Lower payments also allow you to choose how and where you put your money. If you want, you can certainly put extra money toward your mortgage each month, more or less mirroring a standard “fully amortizing” payment. Or, you can invest the money in something else you get to choose. Most house flipping loans are interest-only in order to maximize the amount of money going toward improvements.

Keep costs low

Sometimes an interest-only payment is the only payment you can afford. You might choose an inexpensive property but still come up short on monthly funds. Interest-only loans give you an alternative to paying rent but you can’t ignore the risks.

It’s important to distinguish between true benefits and the temptation of a lower payment. Interest-only loans only work when you use them properly as part of a strategy. It’s easier to get into trouble if you’re just going with interest-only as a way to buy more.

Interest only could make sense when you have irregular income. Perhaps you earn variable bonuses or commissions instead of a steady monthly paycheck. It could work to keep your monthly obligations low and make large lump sum payments to reduce your principal when you have extra funds. Of course, you have to actually follow through on that plan.

You can also customize your amortization schedule with an interest-only loan. In many cases, your additional payments against principal result in a lower required payment in following months. Check with your lender, as some loans won’t adjust the payment.

Drawbacks of Interest-Only

No Equity

You don’t build equity in your home with an interest-only mortgage. You can build equity if you make extra payments, but the loan does not encourage that by design. You’ll have a harder time using home equity loans in the future if you ever need cash for upgrades.

Underwater risk

Paying down your loan balance is helpful for numerous reasons. One of them is reducing your risk when it comes time to sell. If your home loses value after you buy, it’s possible that you’ll owe more on the home than you can sell it for. If that happens, you’ll have to write a large check just to sell your home.

Putting off the inevitable

You’re going to have to pay off the loan someday, and interest-only loans make that day more difficult. We like to believe that we’ll be in a better position in the future, but it’s wise to only buy what you can comfortably afford now.

If you just pay interest, you’ll owe exactly the same amount of money in ten years that you owe now you’re just servicing a debt instead of paying it off or improving your balance sheet.

Risks Associated With Interest Only Loans

• It is a risk when focusing only on the ability to make the interest only payments. The reason is because the borrower will eventually have to pay interest and principal every month. When this occurs, the payment could increase significantly, leading to what is called “payment shock.”
• If the borrower has the payment-option ARM and they only make the minimum payments that do not include the amount of interest due, the unpaid interest is tacked onto the principal. The borrower can end up owning more than what was originally borrowed. If the loan balance grows to the limit of the contract, monthly payments will go up.
• Borrowers may be able to avoid the “payment shock” that is associated with the end of interest only mortgages. However, it is difficult to predict what interest rates will be in ten years, so if the loan balance is higher than the value of the home, refinancing may not be possible.
• Some mortgages, which includes interest only mortgages, have penalties when a borrower prepays. If the loan is refinanced during the repayment penalty period, the borrower may end up owing additional fees. It is important to check with the lender to see if such a penalty may apply.
• The home may not be worth as much as what is owed on the mortgage or it will depreciate quickly if housing prices fall. Even if the prices remain the same, if the borrower has negative amortization they will owe more on the mortgage than what they could get from selling the home. They may find it difficult to refinance and if deciding to sell, may owe the lender more than what would be received from a buyer.

Alternatives to Interest Only Loans

Not everyone can make an interest only loan work. It is important that the borrower do research to see if such a loan is right for their particular situation. If the borrower finds that the interest only mortgage is not right, then there are other options available. If the borrower is not sure that an interest only mortgage is right, there are other alternatives to consider:

• The borrower should find out if they qualify for community housing that offers low interest rates or reduced fees for home buyers making their first purchase. This makes owning a home more affordable.
• It is important to shop around for features and terms that fit the budget, so it may be the right decision to consider a fixed-rate mortgage.
• It is important to take time to save money for a bigger down payment, which reduces the amount that needs to be borrowed, which makes payments more affordable.
• The borrower should look for a cheaper home. Once equity is built, the borrower can buy a bigger and more expensive home.

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