Most loans offer the ability to add an interest-only payment option, which gives you the choice between paying only interest or both the principal and interest in any given month. You must sign up for this type of payment schedule at the time you take out a loan.
Consumers often take advantage of this in order to purchase a more expensive home than they can afford now, with the expectation that their income will rise in the future – perhaps because they will be getting an inheritance, a large raise, a new degree, or a new job. It can also help out business owners who operate in seasonal businesses, as they could pay more when business is strong and retreat to interest-only payments when business is down. For example, if you had a 30 year, $200k home loan at 4%, you would owe $1432 on average under a normal payment schedule and only $1000 if you chose to pay only interest.
While the ability to make a lower payment can clearly be helpful during tough times, a borrower should realize that it will cost them more in the end. An interest-only option effectively delays you paying off your loan, possibly by several years given that you won’t be touching the principal during certain months. Because of the way interest works, a longer loan means that you will end up paying more over time, even if the payments were themselves smaller. Homeowners who go the interest-only route can expect to pay an interest rate that is 0.25%-0.5% higher than normal in return for the added flexibility.
More importantly, they will also literally be mortgaging their futures. If the expected gains don’t materialize, they will be stuck in a mortgage they probably can’t afford. That’s why interest-only loans got a bad reputation after the Great Recession. Many homeowners used an interest-only option to purchase a home they couldn’t realistically afford, simply hoping that their income would rise with the times. When the economy turned south, it took many borrowers who had placed a risky bet with it. In short, they were the poster children of irresponsible lending.
This just goes to show that before taking advantage of this type of loan, you need to make sure that you can handle the loan even if your expected gains don’t work out. Otherwise, you are just gambling on the future instead of making a wise investment.
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