The interest-only (I-0) period on a loan is the time in which you’ll only pay interest on the loan. You do not have to repay any of the original loan balance (the principal) during this time. If you choose this route, you will owe the same amount of money at the end of an I-O period as you did at the start.
I-O periods offer some good benefits, but they can cause trouble with your financial health. Take a look at how these special offers work, why they appeal to people, and when they can cause problems.
What Is the Interest-Only Period?
On a typical loan, you begin paying interest and principal from the very first payment. On a loan with an I-O period, you will pay only the interest for an amount of time that has been agreed upon in advance. It's often a span of months or a few years. During that time, your payments will be much lower than they would be if you were also paying off the original loan amount.
How the Interest-Only Period Works
If you are able to make a large down payment toward your loan and have good credit and a decent income, your lender may offer you an I-O option. They have to see you as a good candidate to repay the loan months or years down the road, so they won't offer this option to just anyone.
During the I-O time, there is no amortization, which occurs when a debt is paid over time with payments of the same amount at regular times. In normal interest loans, each time a payment is made, it chips away at the loan balance. This isn't the case during interest-only periods.
Types of Loans With I-O Periods
I-O periods can be found in fixed-rate mortgages and adjustable-rate mortgages (ARMs). Young people or scholars who take out student loans also face IO periods, especially those who borrow large amounts of money to pay for schooling. Lines of credit, such as a home-equity line, may also have an I-O period.
Pros and Cons of Interest-Only Periods
Building good habits
Low monthly payments at first
Option to refinance later
Large jump in later payments
Hard to predict the future
Not paying down your loan
- Building good habits: Some experts say that students who opt for I-O periods on loans while in school are able to save money and get into the good habit of making regular loan payments. This can help lower the risk that they'll forget to make payments once their loan's grace periods end.
- Low monthly payments at first: Some people prefer loans with I-O periods because it allows them to make early payments that are quite a bit less than their later payments. This option may look good to young people just starting out who can't handle large payments at this point in their careers. They look forward to more financial stability in the future, helping them to make higher payments later in life.
- Option to refinance later: If terms such as the interest rate aren't favorable after the I-O period, you may be able to refinance with a more traditional loan.
- Large jump in payment later: Longer I-O times increase the risk of "payment shock." This is where required payments jump to levels you can't afford. The longer you wait, the larger your required payment will be once you have to repay the principal. With that in mind, it may be better to have a brief I-O time.
- Hard to predict the future: Many people don't have the career or financial success they expect. The death of a spouse, medical problems, or a job layoff may all make it more of a burden to make higher payments during the course of a loan. If you can afford to make higher payments at this time, it may not be wise to put off making these payments now.
- Not paying down your loan: If you only pay interest now, you will still have to repay the entire loan down the road. You could do this through refinancing, but that may prove difficult if your home doesn't increase in value and you haven't paid down any principal.
Is an Interest-Only Loan Period a Good Choice?
In most cases, it's best to take out loans that you'll pay down at a steady pace over time. But there may be some times in which an I-O period makes sense. If you are fairly sure that your income will increase down the road to meet the payment demands or you think you can earn a better return by putting that money someplace else for a short time, an I-O payment may work for you. Be sure you know the risks before you sign on the dotted line.
- An interest-only loan period is an agreed-upon span of time in which a borrower only pays interest and no principal.
- During this time, the loan balance remains the same unless you choose to pay principal.
- The biggest benefit to these is the low monthly payment during the I-O time.
- The biggest downside is the "payment shock" that comes when the time ends and you have to begin paying the full loan payment.