The Definition of the Interest-Only Period
What is the definition of an interest-only period? Simply put, it is a period of time during which you’ll only pay interest on a loan. You do not repay any of the original loan balance (or principal), so you owe the same amount of money at the beginning of an interest-only period as you do at the end. With this overview, get a better understanding of how this period of time in a loan's life affects consumers.
Amortization and Interest-Only Periods
During the interest-only period, there is no amortization. Amortization occurs when borrowers pay off a debt over time with payments of the same amount at regular intervals, usually monthly. Each time the borrower makes a payment, he chips away at interest costs (the way lenders profit from the loan) and the loan balance, or principal. This isn't the case during interest-only periods.
Loan Products Where Interest-Only Periods Take Place
Interest-only periods can be found in fixed-rate mortgages and adjustable-rate mortgages (ARMs). Young people or scholars who take out student loans also face interest-only periods, especially those who borrow large amounts of money to pay for schooling.
Some experts say that students who opt for interest-only periods on loans while in school save money and can get into the good habit of making regular loan payments, lowering the risk that they'll forget to make payments once a student loan's grace periods end.
The interest-only period may last from three to 20 years. Some borrowers prefer loans with interest-only periods because it allows them to make early payments that are significantly less than their later payments. This option may be attractive to young people just starting out who can't handle large payments at this point in their careers but expect to be more financially stable in the future, enabling them to make higher payments later in life.
Of course, it's difficult to predict what life has in store, and many people don't experience the career or financial successes they expected. The death of a spouse, medical problems or a job lay-off may all make it more of a burden to make higher payments during the course of a loan. Accordingly, if you can afford to make higher payments at this time, it may not be wise to put off making these payments now.
If you're still attracted by the idea of loans with interest-only periods, know that you must include principal payments with each payment. If not, you will have to repay the loan (which could happen through refinancing). If you're interested in refinancing your mortgage, you should familiarize yourself with the basics first, including the possible risks, such as having to repay your home loan.
The Dangers of Long Interest-Only Periods
Longer interest-only periods increase the risk of "payment shock," where required payments dramatically 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 relatively brief interest-only period.