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Interest-Only Loans (a.k.a. Interest Only Mortgages)

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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 loan.

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 equity.

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 declining 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 increases.

  • 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

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