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The Definition of an Interest-Only Loan
What are interest-only loans, also known as interest-only mortgages?
When we hear the term "interest-only loan" we intuitively
come to the conclusion that this could actually mean a loan where
the borrower is only responsible for paying the interest on a loan.
Ha! What a beautiful world this would be if that was true! In fact,
an interest-only loan is a type of adjustable-rate mortgage where
the borrower makes no payments on the loan principal for a preset
and very specific amount of time. After that preset time has elapsed,
the borrower is then responsible for making fully amortized payments,
covering both the principal and the interest on the loan,
just as the borrower would pay with a student
loan, a standard mortgage or a car
For more clarity, here's an example of an interest-only loan:
Let's say you've spotted the perfect new
home. You really want this home, but money is tight, so you'll
need to find the most affordable mortgage product that suits your
financial circumstances. You decide to try an interest-only loan.
If you were to walk into a bank and ask for an interest-only mortgage,
the loan officer may offer you an interest-only loan with a five
(5) year fixed rate of interest term, and a full term of 30 years.
If you were to accept the terms of this loan, you would pay only
the interest on the loan for the first five (5) years. As soon as
the five (5) years are up -- in other words, when payment month
#61 comes around -- you would then start making payments covering
both the interest and the principal for this loan (i.e. fully
amortized payments) until the loan is completely paid off.
The interest rate charged by the bank offering the interest-only
loan is usually determined by taking the current LIBOR
rate and adding a margin based on the risk of the loan (the
margin being the bank's profit.)
The Advantages of Interest-Only Loans
What are the advantages of interest-only mortgages? As you might
have guessed already, signing up for an interest-only mortgage means
that during the interest-only period of the loan, monthly payments
are very affordable -- much less than they would be if you were
making standard amortized payments to cover both the principal and
the interest. This means that you would have extra money to play
with during the interest-only period, cash that you can use for
high risk investing, home improvements, starting a business or business
financing, paying down high-interest credit card debt, etc.
Another advantage of interest-only loans is that you get greater
purchasing power for that first or second home. Since most people
in the market for a home expect to increase their income during
the interest-only period of the loan, this often means that the
home buyer can go for a home of higher value than he or she otherwise
would have tried for with a standard mortgage loan.
Other advantages include payment flexibility (i.e. having the option
to payoff part of the principal during the interest-only period
without being penalized) and Unlimited CashOut.
The Disadvantages of Interest-Only Loans
Perhaps the most salient disadvantage to interest-only mortgages
is the potential for "payment shock" once the interest
only period concludes. Once the honeymoon of interest-only payments
is over, the borrower is responsible for making fully amortized
payments to cover both the interest and the principal on
the loan. This can be a devastating situation for borrowers who
fail to plan properly, especially for those on a fixed income.
Of course, another significant disadvantage: by paying only the
interest during the interest-only period, you don't make any headway
with the mortgage principal, which means you won't build any home
If your household isn't very secure financially, then an interest-only
loan could spell serious trouble. Here are a few nightmare scenarios
you should keep in mind:
- You lose your job, or your spouse gets fired from his/her job.
The loss of income can be devastating if it happens when the interest-only
period of your interest-only mortgage is about to terminate.
- You get into trouble with credit card debt, and your credit
score drops significantly as a result. If your plan was to refinance
before the interest-only period terminates, then your low credit
score may make refinancing very difficult, or impossible.
- A generation ago, the typical homeowner would pay down their
mortgage as a reliable way of building home equity over time.
These days, however, many homeowners are relying on the value
of their home appreciating over time as the primary way of building
home equity. But now that home values have been stagnant and even
in various parts of the country, many homeowners are realizing
that home appreciation is not a reliable way of building equity.
So, if you have an interest-only mortgage and the interest-only
period is about to terminate, and the value of your home
hasn't appreciated significantly over time, then selling or refinancing
may cost you dearly, or may not even be possible. In this scenario,
your best option may be to remain in your house, continue to pay
down your mortgage, and wait until your the value of your home
- You purchase a home using an interest-only mortgage. Two years
later, you want to borrow money via a home equity loan (HEL) or
a home equity line of credit (HELOC) to finance something important
like surgery or a business opportunity. You shop around to find
the best possible loan deal, but you find that lenders aren't
willing to offer you a HEL or a HELOC, because the value of your
home hasn't increased significantly and you haven't built equity
by paying down the principal of your mortgage.
- You use an interest-only loan to buy your dream house, a house
you wouldn't have been able to afford had you financed the purchase
with a 30-year, fixed interest rate mortgage. Four years later,
you realize that the neighborhood has declined, and you start
to think about selling. You hire a professional appraiser to get
an accurate valuation of your home, and you find that the value
of your home has actually declined significantly since you bought
it (also known as negative equity.) You sell your house anyway,
because you desperately want out, and you end up losing thousands
because you have no choice but to sell at a price that is far
below the price you paid four years ago. In this scenario, buying
a home has actually set you back financially, and you realize
that you would have been better off renting.
Interest-Only Loans Summary
Though interest-only loans offer lower monthly payments than standard
mortgage loans -- and we all want lower monthly payments! -- they
are not for individuals who could not otherwise afford a
standard mortgage loan. To be quite frank, interest-only mortgages
are for relatively wealthy individuals (they were created for the
wealthy!) who have lots of savings in the bank and who also typically
have short term home-ownership needs. Bottom line: interest-only
loans are perfect for people who plan on selling or refinancing
a given property before the interest-only period ends.
So, if you are wealthy enough, and very confident about the future
of your finances, then an interest-only loan is probably a safe
financing option for you. When shopping for an interest-only mortgage,
look for a loan that has a fixed interest rate as opposed to an
adjustable rate (yes: fixed rate, interest-only loans do exist!),
Also, try to get a loan with no prepayment penalties, so that you
will have the freedom to pay more than just the interest-only payment
each month, if you want to.
by Steve "AmCy" Brown, FedPrimeRate.comSM