Interest-Only Loan: A Guide to Definition and Financial Implications

Author

Posted Dec 30, 2024

Reads 4.9K

Real estate business finance background template. Calculator door key.
Credit: pexels.com, Real estate business finance background template. Calculator door key.

An interest-only loan is a type of loan where you only pay the interest on the borrowed amount for a certain period of time, usually 5-10 years.

This means you won't pay down the principal balance, which is the actual amount you borrowed.

The monthly payment for an interest-only loan is typically lower than for a traditional loan, since you're only paying interest.

However, this comes with a big catch: you'll owe the full principal amount at the end of the interest-only period, which can be a significant financial burden.

What Is a Interest-Only Loan?

An interest-only loan is a type of loan where you only pay the interest on the loan for a set period of time, usually 5-7 years.

The interest rate on an interest-only loan is often lower than a traditional loan, making it a more attractive option for some borrowers.

You won't be paying down the principal balance of the loan during the interest-only period, which means you won't own the property until the loan is re-amortized.

Credit: youtube.com, The Hidden Secrets to Improved Your Cash Flow - Interest Only Loans

The monthly payments on an interest-only loan are typically lower than a traditional loan, but you'll be paying more in interest over the life of the loan.

As the interest-only period comes to an end, the loan will be re-amortized and you'll start making payments on the principal balance.

This can be a good option for people who expect their income to increase significantly during the interest-only period, allowing them to make larger payments.

However, if your income doesn't increase as expected, you may struggle to make larger payments when the loan is re-amortized.

Benefits and Risks

An interest-only loan can be a good option for some people, but it's essential to understand the benefits and risks involved.

The most obvious benefit of an interest-only mortgage is that monthly payments are initially considerably lower than those of typical loans. This can be a huge advantage for people who are expecting a significant income boost in the coming months and years.

Credit: youtube.com, When should you use Interest Only Loans? (Pros & Cons)

You can enjoy a larger home for less money while you save up for a larger mortgage, assuming you have a sound plan in place for when those larger payments eventually kick in.

Interest-only payments are smaller than conventional mortgage payments, and the interest rate may be fixed during the first part of the loan. This can be a huge advantage for people who are looking to buy a home but don't have a lot of money for a down payment.

However, interest-only loans can be risky when the interest-only period is up and it's time to start paying principal. Since new federal consumer-protection guidelines took effect in 2013, lenders know what sort of loans they can offer and to whom.

You won't build up any equity in your home until you begin principal payments, which can be a major disadvantage. This means that if you take out an interest-only mortgage, you'll likely make no money from the sale of your home unless the market has boomed exponentially since closing.

Here are some key things to consider before pursuing an interest-only mortgage:

  • No Equity Growth: Interest-only mortgages generally require large down payments, so lenders have collateral against default. But for the first 5-to-10 years, the homeowner's equity doesn't grow at all, unless you make extra payments.
  • Home Values are Not Consistently Rising: Prior to 2008, many homebuyers believed housing prices would never fall. They learned a hard lesson. Interest-only loans contributed to the rapid jump in prices, but when the bubble burst and prices fell, interest-only mortgage holders were suddenly making big interest payments on houses in which they had little or no equity.
  • Riskier Loans with Higher Interest Rates: Interest-only loans were once easy to sell to other financial institutions. Now, lenders demand larger down payments from borrowers, and they charge higher interest than on conventional loans. Mortgage interest rates correspond to risk. The more risk to the lender, the higher the rate.
  • Variable Interest Increases: Interest-only loans often come with variable interest rates. So, the amount of interest you pay on your mortgage or HELOC can increase. You might want to look for loans that allow you to lock and unlock interest rates, allowing you greater certainty about future payments.

Calculating and Paying

Credit: youtube.com, How to Calculate an Interest-Only Loan

Calculating an interest-only mortgage payment is a straightforward process. You simply multiply the loan balance by the annual interest rate, then divide by 12.

For instance, if you borrow $100,000 at a 5% interest rate, your calculation would be (100,000 x .05)/12 = $416.67, which is your interest-only payment per month.

At the end of the interest-only term, your payments will increase to cover both principal and interest, and will marginally change as you pay off the mortgage.

Calculating Payments

Your interest-only mortgage payment is calculated by multiplying the loan balance by the annual interest rate, then dividing by 12.

For example, if you borrow $100,000 at a 5% interest rate, your monthly payment would be $416.67.

Payments will increase to cover both principal and interest after the interest-only term, and the new monthly payment amount is based on the remaining principal.

This means that as you pay off the mortgage, your payments should marginally change.

30-Year Loans

Credit: youtube.com, How to Pay Off Your Mortgage Early (The Ugly TRUTH About Mortgage Interest)

30-Year Loans are a popular option for homebuyers, but did you know that some 30-year interest-only mortgages don't require principal payments for the first 10 years?

This means that borrowers won't be paying down the loan balance during the initial 10 years, which can be a relief on their monthly payments.

The repayment period for these loans is the same as a standard 30-year loan, but the higher principal payments in the final 20 years can be a challenge.

Lenders often require larger down payments and charge higher interest rates to offset the risk of default.

Borrowers should carefully consider their financial situation before opting for a 30-year interest-only mortgage.

Eligibility and Options

To qualify for an interest-only mortgage, you'll typically need a credit score of 680 or above. This is a higher standard than conventional loans.

Interest-only mortgages are better suited to borrowers with lots of cash in reserve, as they need to be prepared to cover the principal payments when the interest-only period ends. Borrowers who see their income significantly rising in the near future may also find interest-only mortgages appealing. Those disciplined enough to redirect income spikes toward paying down the principal can also benefit from this type of loan.

For another approach, see: Principal Balance

Loan Eligibility

Credit: youtube.com, Boost Your Personal Loan Eligibility: The Best Tips

To qualify for an interest-only mortgage, you'll typically need a credit score of 680 or above, as lenders require a higher credit score than conventional loans.

Interest-only mortgages often require a larger down payment, which means you'll need to save up a bigger chunk of cash upfront.

Borrowers with a lower debt-to-income (DTI) ratio are more likely to qualify for an interest-only mortgage, as lenders use this ratio to determine your ability to repay the loan.

You'll also need to provide proof of income to lenders, which can be a challenge if you're self-employed or have irregular income.

Interest-only mortgages are best suited for borrowers who have lots of cash in reserve, as they'll need to redirect income spikes toward paying down the principal sooner rather than later.

A unique perspective: No down Payment Car Financing

Types of Home Loans

Interest-only home loans are still available, but lenders are more cautious now.

Interest-only jumbo mortgages are a type of interest-only loan that's popular among wealthy buyers. These large loans can be up to $650,000.

To qualify for an interest-only jumbo mortgage, borrowers must meet high standards. This is due to the Dodd-Frank Act, a federal law passed in 2010 to prevent another housing-market meltdown.

Alternatives and Considerations

Credit: youtube.com, Interest-Only Loans For Investment Properties │ Ask Ryan

If you're not sold on an interest-only mortgage, there are other options to consider.

You can explore government-backed loans like those from the Federal Housing Administration (FHA), which can give you more affordable payments without the future jump that comes with an interest-only mortgage.

If you're looking for a mortgage with a long, low-interest introductory rate period, many adjustable-rate mortgages fit the bill. These loans will allow you to build equity while keeping your payments low.

Some people might find it helpful to consider the following scenarios:

  • You’re in graduate school and want to keep repayments low for now — but anticipate having a high-paying job in future
  • You have a trust that will start releasing assets at a future date
  • You flip houses and need to keep expenses down during the remodel
  • You expect to move before the end of the introductory period

Alternatives

If you're hesitant about taking on an interest-only mortgage, there are alternatives to consider.

Many adjustable-rate mortgages have a long, low-interest introductory rate period, which can be a more stable option.

These mortgages include payments that build equity, giving you a sense of security and a tangible benefit.

Government-backed loans, such as those from the Federal Housing Administration (FHA), can provide more affordable payments without the risk of a future jump in payments.

These loans are a great option if you're looking for a lower monthly payment without sacrificing long-term stability.

See what others are reading: How Long Does a Home Loan Application Take

Should You Consider?

Smartphone with Opened Calculator Lying on a Document with an Income Statement
Credit: pexels.com, Smartphone with Opened Calculator Lying on a Document with an Income Statement

If you're considering an interest-only mortgage, you'll want to carefully evaluate your financial situation and goals. Borrowers who are in graduate school and expect a high-paying job in the future might find an interest-only mortgage a good fit, as it allows them to keep payments low for now.

You should also consider your financial stability. If you have a trust that will start releasing assets at a future date, you might be able to rely on those funds to cover the higher monthly payments. However, this is just one factor to consider.

Some people might find interest-only loans useful if they flip houses and need to keep expenses down during the remodel. In this case, the loan can help you manage your finances during a potentially costly process.

If you expect to move before the end of the introductory period, an interest-only mortgage might be a good option. This can give you time to sell your current home and purchase a new one without worrying about the higher payments.

Frequently Asked Questions

Why would you get an interest-only loan?

You can get an interest-only loan to save money during the loan period by reducing your repayments, allowing you to pay off other debts or build up savings. This type of loan is ideal for people who need short-term finance to cover the gap between buying a new property and selling their existing one.

What is one advantage of an interest-only loan?

One advantage of an interest-only loan is that it requires lower payments during the interest-only period, allowing for more flexibility in your finances. This can be especially helpful for properties that need renovations or have lower occupancy rates.

What is a main disadvantage of the interest-only loan?

A main disadvantage of an interest-only loan is that you don't build equity in your home until you pay off the principal, leaving you vulnerable to losing your down payment if the home's value declines. This can result in a significant loss of investment.

How is an interest-only loan paid off?

After the initial interest-only period, you'll need to start making payments that cover both interest and principal, which can increase your monthly payments significantly. This is typically done by refinancing or converting to a new loan with a different payment structure.

Do banks still do interest-only mortgages?

Yes, banks still offer interest-only mortgages, but they're less common and approval is subject to lender discretion. Interest-only mortgages require a repayment plan to be in place when the mortgage ends.

Vanessa Schmidt

Vanessa Schmidt

Lead Writer

Vanessa Schmidt is a seasoned writer with a passion for crafting informative and engaging content. With a keen eye for detail and a knack for research, she has established herself as a trusted voice in the world of personal finance. Her expertise has led to the creation of articles on a wide range of topics, including Wells Fargo credit card information, where she provides readers with valuable insights and practical advice.

Love What You Read? Stay Updated!

Join our community for insights, tips, and more.