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What is an Interest Only Loan?

Updated: Apr 1, 2019

A loan that allows you to make payments that cover only the monthly interest charge is called an interest-only loan.  While you can pay more than the interest, you are not required to.  One of the main reasons interest-only loans are popular is because they reduce your required monthly payment and give you greater flexibility overall.

However, it’s important to remember that the payment on an interest-only loan is just that; interest-only.  If you choose to make an interest-only payment, the principal balance will remain the same.  For example, the interest-only payment on a $300,000 loan with a rate of 4.0% is $1,000.00.  If you made the interest-only payment for the first ten years of the loan, the balance would still be $300,000 at the end of the tenth year.  On the other hand, the fully amortized principal and interest payment for a fixed 30-year loan of $300,000 at 4.0% would be $1,432.  This payment covers both principal and interest and would pay off the loan over the 30-year loan term.  The principal balance at the end of the tenth year on the fully amortized loan would be $236,351.

It is also important to note that with interest-only loans the option to pay interest-only lasts for a specified period, usually 5 to 10 years.  This means that the monthly payment will likely increase when the interest-only option expires.

Is an Interest-Only Mortgage Suitable for Me?

These types of mortgages are typically best for borrowers who will benefit from a lower introductory payment and who are not concerned with the payment rising in the future.  Here are some examples where this type of loan would make sense:

You want to buy a more expensive house: Since an interest-only loan is a reduced payment, it can often allow a borrower to purchase a more expensive home than they might be able to with a standard principal and interest loan.

You want to pay principal at your convenience: If a borrower has a fluctuating income, they may value the flexibility the interest-only mortgage gives them.  If their finances are tight, they can make the interest-only payment and then when they’re flush they can make a much larger payment to principal.

You want to invest the cash flow: Many homeowners prefer to build wealth by paying down mortgage debt.  However, some may build wealth more quickly by investing their excess cash flow instead of paying down their mortgage.  In order for this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.

While these are just a few reasons that a borrower may choose an interest-only loan, know that every borrower is unique. Just because interest-only loans are a favorite among many borrowers, it might not be the right one for you.  If you want to learn more about interest-only loans, as well as other available options, please don’t hesitate to contact us.

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