Interest Only Loans

How Interest Only Loans Work

Money Trap
That low payment can be tempting. Make sure you've got the right strategy. sorbetto/DigitalVision Vectors/Getty Images

An interest only loan is a loan that you only make interest payments on (until the interest only period ends, which is often five to ten years). Because you’re only paying interest charges each month – as opposed to interest plus a portion of your loan balance (also known as the principal) – your payments are lower than they’d be with a traditional amortizing loan.

To calculate the payment on an interest only loan, calculate the loan balance by the interest rate.

For example, if you owe $100,000 at 5%, you’d owe $5,000 per year or $416.67 per month.

Interest only loans eventually convert to standard amortizing loans (with higher payments) after the “interest only period” ends – typically five or ten years.

Benefits of Interest Only Loans

Interest only mortgages are appealing because your monthly payments are lower. What are some popular reasons (or temptations) for going with a lower payment?

Buy a more expensive property: an interest only loan allows you to buy a more expensive home than you would be able to afford with a standard fixed rate mortgage. Lenders calculate how much you can borrow based (in part) on your monthly income, using a debt to income ratio. With lower required payments on an interest only loan, the amount you can borrow goes up significantly.

If you’re confident that you’ll be able to afford a more expensive property – plus you’re willing and able to take the risk that things won’t go according to plan – an interest only loan makes it possible.

Free up money: lower payments also allow you to choose how and where you put your money. If you want, you can certainly put extra money towards your mortgage each month, more or less mirroring a standard “fully amortizing” payment.

Or, you can invest the money in something else (like a business or other financial goals) – you get to choose.

Keep costs low: sometimes an interest only payment is the only payment you’ll be able to afford. You might choose an inexpensive property but still come up short on monthly funds. Interest only loans give you an alternative to paying rent – but there are risks to taking this route.

It’s important to distinguish between true benefits and the temptation of a lower payment. Interest only loans only work when you use them properly – as part of a strategy (and not just a way to keep your expenses low).

For example, they’re a good option when you have irregular income (if you get variable bonuses or commissions instead of a steady monthly paycheck, for example). It might work to keep your monthly obligations low and make large lump-sum payments to reduce your principal when you have extra money. Of course, you have to actually follow through on that plan.

You can also customize your amortization schedule with an interest only loan.

See How Amortization Works for details on how amortization affects your mortgage. In many cases, your additional payment against principal will result in a lower required payment in following months (because the principal amount that you’re paying interest on has decreased). Check with your lender, as some loans won’t adjust the payment (or the payment doesn’t get adjusted immediately).

Drawbacks of Interest Only

That lower monthly payment comes at a cost. So what do you give up when you only pay interest on your loan?

No equity: you don’t build equity in your home with an interest only mortgage. You can build equity if you make extra payments, but the loan does not encourage that by design. You’ll have a harder time using home equity loans in the future if you ever need cash for upgrades.

Underwater risk: paying down your loan balance is helpful for numerous reasons. One of them is reducing your risk when it comes time to sell. If your home loses value after you buy, it’s possible that you’ll owe more on the home than you can sell it for (known as being upside-down or underwater). If that happens, you’ll have to write a large check just to sell your home.

Putting off the inevitable: you’re going to have to pay off the loan someday, and interest only loans make that day more difficult – the day will come. We like to believe that we’ll be in a better position in the future, but it’s wise to just buy what you can comfortably afford now.

If you just pay interest, you’ll owe exactly the same amount of money in 10 years that you owe now – you’re just servicing a debt instead of paying it off or improving your situation.

Example: assume that you buy a home for $300,000 and you borrow 80% (or $240,000). If you make interest only payments, you’ll owe $240,000 on that home (until the interest only period ends). If the home loses value and is worth only $280,000 when you sell it, you won’t get your full $60,000 from the down payment back. If the price drops below $240,000 when you sell, you’ll have to pay out of pocket to repay your lender and get the lien on your home removed.

Of course, you have to pay your loan off one way or another. Usually, you end up selling the home or refinancing the mortgage to pay off an interest only loan. If you end up keeping the loan and the house, you’ll eventually have to start paying principal with each monthly payment. Again, this conversion might happen after 10 years. Your loan agreement will explain exactly when the interest only period ends and what happens next.

Interest only loans aren’t necessarily bad. But they’re often used for the wrong reasons. If you’ve got a solid strategy for alternative uses for the money you’d otherwise pay towards principal (and a strategy for getting rid of the debt), then they can work well. Choosing an interest only loan for the sole purpose of buying a more expensive home is a risky approach.

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