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How Interest Only Loans Work

Interest only loans may seem to be an easy way to borrow money, since you only have to pay interest only. Compared to a traditional amortizing mortgage (such as car loans or home loans) you have to pay both interest and principal in every monthly payment, so this amount becomes larger and takes up more of your available cash. Interest only loans offer very low monthly payments, which is why some people prefer it over a normal installment loan for 12 months. However, note that the amount you owe will never decrease since you are not paying down the principal.

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Interest Only Loans Benefits

A lot of people wanted to know whats the benefits of interest only loans and should they take one. The main benefit is simply lower monthly payment compared to traditional installment loans, which opens up more choices for the borrowers. For example, they can choose to buy a bigger home yet make smaller monthly payments. You may need a larger home to accommodate your family but your current income does not allow you to do so with a normal fixed rate home loan. you can either wait until your income progressively increases or take an interest only loan for the first few years of home ownership.

Interest only loans can work very well in the short term but many people forget that they still owe the lenders a lot of money. So you need to use them properly. With the smaller monthly payments for interest only loans, it is easy to avoid late payments that can damage your credit score. However you should save up the surplus cash every month and make payments against the principal regularly. This is especially true if you do not have regular income, as many people face difficulties while trying to find lenders for self employed.

It is also possible to customize your amortization schedule with interest only loans. After making principal payments, your subsequent interest only monthly payments will also decrease since the the principal debt is now lower. You can the difference in monthly payments between a normal amortizing home loan versus an interest only loan using any free online calculators.

Dangers of Interest Only Loans

Note that interest only loans can become very costly if you are borrowing money without making principal payments. For many homeowners with interest only mortgage loans, they do not have any equity in their homes after 10 years or more. Thus, they have not been building any wealth through home ownership and they cannot use home equity loans in times of need. During this period, if your home value drops, the lender may ask you for the shortfall or even force you to sell it. If you are not able to make principal payments on interest only home loans, you may as well rent a home with less troubles.

For example, you wanted to buy a home for $300,000, and you borrow 80% ($240,000) on a interest only loan. If you do not make any principal payments, you will still owe $240,000 on that home even after 5 years of paying on time every month. If your home value drops below $240,000 and you wanted to sell it, you have to pay for the short fall between the amount you owe and the final sale price you get for your home. Since you need to pay back money you borrow, interest only loans are only suitable as a temporary bridging solution. Furthermore, most lenders will only give interest only home loans up to 10 years. Usually, you end up having to sell the home or take a refinance to pay off the first loan. An interest only home loan may help you out for the next few years, while hoping for your income to increase. It can be great to buy a home for cheap now using an interest only loan instead of waiting for home prices and your income to both increase and offset each other. Do make sure you understand the potential problems of interest only loans.


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