Real Estate Guide

Your Mortgage - Questions and Answers
'Interest Only Loan'

• What is an Interest only Loan?
• What are the advantages of an interest only loan?
• What are the disadvantages of an interest-only loan?

What is an Interest only Loan?

An interest-only loan is a loan for a set period or term (usually 5 to 10 years)  during which the borrower's payments are based only on the interest calculated on the principal balance (the principal balance remains unchanged during the term). At the end of the interest-only term the borrower may pay the principal balance in full, or (with some lenders) convert the loan to a conventionally amortized loan.

For example if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized (payments for both interest and principle) for the remaining period of twenty years. The interest-only early payments are of course substantially lower than the later (interest + principal) payments. Note, however, that the later payments are substantially higher than they would be had the loan been fully amortized from the start.

What are the advantages of an interest only loan?

The major advantage of the interest-only loan of course, is that you won't spend monthly cash to pay down the principal as in a fully amortized loan. As a result you free up money to invest in more lucrative vehicles or to buy other real estate.  Many financial experts recommends using interest-only loans to get on with these long term wealth-building goals.

But other experts warn that there is no free lunch. If you can't afford a conventional loan for the purchase, you're taking a huge, maybe ruinous, risk if you enter into a interest-only loan. All that happens with interest-only loans is that you put off the inevitable. When the principal payments are added to the mix — you're mortgage payment will spike.

What are the disadvantages of an interest-only loan?

The major disadvantages may be summarized as follows:

• Interest-only loans are riskier for lenders, therefore,  the interest rate on a interest-only mortgage will normally be higher than with a conventionally amortized loan.
• Consumers put themselves at huge risk when they combine interest-only loans with little or no down payment varieties, or an adjustable rate (ARM) mortgage. When the interest-only term expires, the monthly payments in these situations,  may  well be beyond the means of the homeowner.
• You will not build any equity in an interest-only loan and can't predict  market conditions when the term ends. Therefore when the interest only term ends, at the time your want to sell your home or must refinance:
  1.  you may find that you can't afford the substantially higher amortized payments
  2. refinancing becomes difficult or impossible because you have no equity in the home
  3. you can't sell because demand for housing has weakened.
      

From 2000 through most of  2006, homeowners in some areas may have seen their home's value spiral 3 to 5  times its original price. Interest-only loans were effective in this period, allowing buyers to 'get more home for their money.'  However,  in 2007 the bubble burst, demand for housing weakened and interest-only loans contributed to the current bleak foreclosure situation. Interest-only loans only work for the buyers in markets where housing prices are consistently rising. If housing prices drop, borrowers may be forced to sustain a mortgage that's larger than the value of the house - unable to sell - and unable to refinance.