If a lower mortgage payment sounds like just what you need, interest-only loans might be something you consider. Before you take on this alternative loan, you should know how it works as well as the pros and cons to determine if it’s a good fit for you.
How Interest-Only Loans Work
Interest-only loans, as the name suggests, only require you to pay interest for a certain period. The typical interest-only loan requires interest payments only for 10 years. After that 10 years, your principal is amortized over the remaining 30 years of the term.
Once your loan is out of the interest-only period, you pay a much higher payment because you now pay principal and interest. Because the interest is amortized over 20 years, rather than 30 years, you make a larger payment towards the principal.
Who Benefits From Interest Only Loans?
Interest-only loans are not for the average borrower. Even though you get a lower payment initially, the higher payment and lack of equity in the home make it a loan best reserved for the following types of borrowers:
- Homebuyers that know they will move before the interest-only period ends
- Borrowers with a large amount of liquid assets
- Borrowers with the ability to make lump sum payments towards principal
- Borrowers that know their income will increase significantly in the future (new doctors, for example)
The best way to handle an interest-only loan is to make principal payments as you can. It doesn’t have to be monthly. For example, if you receive a large bonus each year and you apply the total amount to your principal, you might benefit from this loan structure.
The Pros of the Interest-Only Loan
The interest-only loan sounds risky, but there are some benefits you may realize:
- A lower payment – This is the main reason many people take this loan type. They want the lower payment. Whether it’s because you have lower income now than you will in the future or you just want to keep your payments down as you start homeownership, you do save money for the interest-only portion of the term.
- Better cash flow – Without the requirement to make principal payments, you may have greater cash flow to invest as you see fit. Some borrowers don’t make principal payments, but rather invest their money somewhere that they know they can make a better return on their investment than they would make in their home.
- Low minimum payment – If you have irregular income, the interest-only loan can make it easier to afford your payment when your income is low. This works well for commission borrowers that have good months and bad months. During the good months, they can pay the principal down and during the bad months, they just have to make sure they cover the interest portion of the loan.
The Cons of the Interest-Only Loan
The interest-only loan definitely has some downsides that you should know about:
- You don’t gain equity – Without paying down the principal on your home, you do not gain any equity in the home. If you do move within a few years, you will have to pay back the same amount you borrowed. All you did was pay interest on the loan and never really got ahead on your investment.
- You might get in over your head – If your home loses value and you never touched the principal balance, you might find yourself underwater. This means you owe more on the loan than the home is worth. This may leave you stuck in your home unless you want to pay the difference between the sales price of the home and the loan payoff amount.
- Higher payments – Once you do start paying principal on the loan because the interest-only period ended, you will make higher payments. You’ll have fewer years to pay the loan balance back, which means the lender will require higher principal payments for the remainder of the term.
Interest-only loans are not Qualified Mortgages. In other words, you cannot go to your standard lender and get this type of loan. You will have to seek out an alternative lender or one that keeps loans on their own books. These lenders make their own terms and create their own rates – they don’t have to follow the QM rules, which may mean the loan costs you a little more in the end. Make sure you shop around to find a lender that offers the loan you can afford.Click to See the Latest Mortgage Rates»