What is an interest only loan?

An interest only loan can be a life saver for first time home buyers.  For many in today’s struggling economy, going from a rental payment to a mortgage payment can sometimes be frightening.  Conventional loan payments can be nearly double what renters were once paying which is why an interest only loan is oftentimes more appealing.  Interest only payments help transition renters to home owners, by offering a lower mortgage payment during the early months of a loan.

With an interest only payment, the first five or ten years of payments go towards the interest only.  Let’s say you purchase a home for $250,000 at an interest rate of 6.5%.  For the first 10 years of a 30 year loan, you are going to pay roughly $1354.  For the remaining twenty years of the loan the mortgage payment will go up to roughly $1863.

The reason these loans are risky for some is because of this drastic increase in payments after that initial period.  The reason for the higher payments is that after those first ten years, you now have to pay towards the actual principal of the home.  It is always advised that homeowners realize and understand this before accepting an interest only loan.  While the lower payments may be nice in the beginning, home owners need to understand and budget for the time when the payment amount will go up.  The nice thing about interest only payments though is that you can always pay towards the principal during the first ten years in order to pay off your mortgage faster.

One final thing to consider regarding interest only loans is that compared to traditional loans, the interest rate will be higher.  Lenders increase the interest rate about of a percent in order to benefit from offering these types of loans.

In the end, it comes down to two things:

1) Can you afford a traditional mortgage payment?

2) Are the additional interest and higher payments in the end worth paying lower payments today?

Like stated, interest only loans can be a life saver as long as you understand the terms associated with them.

An interest-only loan is a type of repayment plan that gives a borrower the choice to pay back just the interest charges on a loan for an introductory period, rather than paying both interest and a portion of the loan’s principal. This means that the principal never decreases, and the loan is not actually being paid back during the introductory period, which may last for several months or even many years, depending on the type of loan.  After the introductory period ends the loan will work just like a normal loan. While auto loans or personal loans can have interest-only periods, this type payment plan is most commonly used on adjustable rate or a fixed rate mortgages.

Interest-only loans usually have higher interest rates than loans without the interest-only option because lenders perceive them to be riskier. Usually an interest-only loan has an interest rate that is 0.25% - 1% higher than that of a standard loan.

Interest-only loans are usually a good option for borrowers who:

• Expect their incomes to rise – A borrower who anticipates their income to rise substantially in the future can use an interest-only loan to secure a larger loan now, in anticipation of being able to make larger payments later.
• Have irregular cash flows During tight periods a borrower can use the interest-only option to make small payments, and during busy periods the borrower can make larger payments to make up for the earlier small payments.

Borrowers should be cautious when looking at an interest only loan. After the introductory period ends, the payments can rise dramatically because the borrower has to begin paying back both the principal and the interest on the loan. This can lead to payments up to two times as much as their original payment. During the financial crisis this pushed many borrowers into foreclosure. It is easy to assume your income will rise in the future, but if those gains never materialize, a borrower can be left with a loan they simply cannot afford.

Borrowers sometimes have problems comparing interest-only mortgages because they don’t realize such mortgages are usually also ARMs. When they compare it to a more conventional fixed rate mortgage, they find a lower rate, but that is because they are comparing two different types of mortgages. To find the true cost of an interest-only option, a borrower needs to compare a traditional ARM against an ARM with an interest-only option.

Another common misconception about interest-only mortgages is that they allow a borrower to avoid paying for mortgage insurance. With a standard mortgage your mortgage insurance payment will be listed as a separate itemized cost, while with most interest-only loans the cost of mortgage insurance is simply folded into and hidden inside the loan.