An interest-only loan is an adjustable-rate mortgage that allows the borrower to pay just the interest rate for the first few years. That's often a low "teaser" rate.
That introductory period typically lasts between three to 10 years. After that, the loan converts to a conventional mortgage. The interest rate may increase and the monthly payment must also cover some of the principal. That increases the payment significantly. Some interest-only mortgages require the borrower to pay off the entire balance after the introductory period.
Interest-only loans are also called exotic loans and exotic mortgages. Sometimes they are called subprime loans even though they weren't only targeted to those with subprime credit scores.
Advantages of Interest-Only Loans
The first advantage is that the monthly payments on an interest-only mortgage are initially lower than those of a conventional loan. That allows borrowers to afford a more expensive home.
That only works if the borrower plans to make the higher payments after the introductory period. For example, some increase their income before the intro period is over. Others plan to sell the home before the loan converts. The remaining borrowers refinance to a new interest-only loan, but that doesn't work if interest rates have risen.
The second advantage is that a borrower can pay off an interest-only mortgage faster than a conventional loan. Extra payments go directly toward the principal in both loans. But, in an interest-only loan, the lower principal then generates a slightly lower payment each month. In a conventional loan, it reduces the principal, but the monthly payment remains the same. Borrowers can pay off the loan faster, but they don't realize the benefit until the end of the loan period. An interest-only loan allows borrowers to realize the benefit immediately.
The third advantage is the flexibility an interest-only loan provides. For example, borrowers can use any extra money, such as bonuses or raises, to apply toward the principal. That way, they don't notice a difference in their standard of living. If they lose their jobs or have unexpected medical costs, they can go back to paying just the interest amount. That makes an interest-only loan superior to a conventional mortgage for disciplined money managers.
Disadvantages of Interest-Only Loans
First, interest-only loans are dangerous for borrowers who don't realize the loan will convert. They often cannot afford the higher payment when the teaser rate expires. Others may not realize they haven't got any equity in the home and if they sell it, they get nothing.
The second disadvantage occurs for those who are counting on a new job to afford the higher payment. When that doesn't materialize, or if the current job disappears, the higher amount is a disaster. Others may plan on refinancing, but if interest rates rise, they can't afford to refinance, either.
The third risk is if housing prices fall. That hurts homeowners who plan to sell the house before the loan converts. In 2006, when the housing boom ended, many homeowners weren't able to sell because the mortgage was worth more than the house. The bank would only offer a refinance on the new, lower equity value. Homeowners that couldn't afford the increased payment were forced to default on the mortgage. Interest-only loans were a big reason so many people lost their homes.
Types of Interest-Only Loans
There were many types of subprime loans based on the interest-only model. Most of these were created after 2000 to feed the demand for subprime mortgages. Banks had started financing their loans with mortgage-backed securities. These derivatives became so popular they created a huge demand for the underlying mortgage asset. In fact, these interest-only loans are part of what really caused the subprime mortgage crisis.
Here is a description of these exotic loans. Their destructiveness means that many are no longer available.
- Option ARM loans allowed borrowers to choose their monthly payment amount for the first five years. ARM stands for adjustable-rate mortgage.
- Negative amortization loans added to, rather than subtracted from, the principal each month.
- Balloon loans required the entire loan to be paid off after five to seven years.
- No-money-down loans allowed the borrower to take out a loan for the down payment.
The Bottom Line
Interest-only home loans can be useful to borrowers who are informed about how they work and disciplined about managing their money. If you're not sure if you could afford the monthly payment once your monthly payments increase, you may be a better fit for another type of mortgage.