The Interest-Only Loan

With home prices soaring and it becoming harder for some people to qualify for loans, the interest-only loan has begun to gain in popularity. As the name implies, with an interest-only loan you only make interest payments for a certain number of years, which saves money every month but it also means that the principal of your loan is not paid down during the interest-only period of the loan.

For some people this can be a benefit. Should cash flow present a problem at the beginning of your loan, then you may opt to just pay the interest on the loan rather than pay on the principal portion of the monthly payments. Depending on the size of your mortgage, this strategy can put an extra $100 or $200 or even more in your pocket each month.

An interest-only loan can also be used to help a borrower qualify for a larger loan (to be put towards a bigger house) than they could if they had to make a fully amortized payment each month.

Generally speaking, an interest-only loan starts out as a fairly typical mortgage loan and has an interest-only option written into the terms of the agreement. In most cases, the loan will be interest-only for the first three years, five years, seven years, ten years, or fifteen years. At the end of the interest-only portion of the loan then arrangements must be made to pay the principal of the loan.

Principal can be paid in a couple of different ways. One way is to sell the property. This works well in areas where property values are rising and when a borrower only intends to live in a home for three, five, seven or ten years. The homeowner can enjoy lower monthly payments for a certain number of years and then sell and take out whatever equity that inflation and rising home prices has created.

There are a couple of risks in doing this. If housing prices go down before you are forced to sell you could end up with a debt to pay out of your own pocket. Also, if you are forced to sell at a certain time you must be confident that the market will be there when you need it.

In many cases, however, the interest-only loan has a conversion clause built into it. At the end of the interest-only period then the loan automatically converts into a fully amortized loan that must be paid off in the time remaining on the original loan.

Here’s how that works. Let’s assume you take out a 30-year mortgage with an option to make interest-only payments for the first 15 years of the loan. At the end of fifteen years the loan automatically converts into a fully amortized loan that must be paid off in the fifteen years that are remaining on the original 30-year loan.

That would mean a huge jump in monthly mortgage payments. Suddenly the entire principal of the loan, plus the regularly accrued interest, would need to be paid back in 15 years.