Market Insights

When to Consider an Interest-Only Loan

Couple looking at debt consolidation options and considering an interest only loan

You may not hear as much about interest-only loans these days, and many lenders don’t offer them, but they are available through some lenders. If you are curious about this type of loan, it is important to understand how it works.

What Is an Interest-Only Loan?

An interest-only loan allows you to pay back only the interest on your loan for a set length of time, usually 5, 7 or 10 years. At the end of that period, the amount of principal owed is re-amortized over the remainder of the loan term and payments are adjusted accordingly. You may make principal payments during the interest-only period if you choose.

For instance, if you have a $300,000 loan and you reduced the principal by $20,000 during the first 10 years, the $280,000 will be re-amortized for the next 20 years. This will result in an increase in your payments. However, any time you make a payment on the principal, your interest payments will be reduced immediately.

Who Benefits from an Interest-Only Loan?

An interest-only loan is not as popular as it once was, especially after the housing crisis resulted in many people owing more on their homes than they were worth. Nevertheless, there are times when people may find interest-only loans appealing:

Borrowers with non-traditional income

Buyers who rely on commission or bonuses may want to have a lower monthly payment and then pay on the principal when they receive their additional income. People who own businesses with fluctuating revenue may also prefer this type of loan, so they can pay the principal in a large sum without worrying about higher payments each month.

Borrowers with expected income increases

Recent college graduates and other borrowers who expect a dramatic increase in income may want to have a lower monthly payment for a period of time, expecting their income to rise and afford the re-amortized payment at the end of the interest only period. If they know they will be able to handle a larger payment in the future, an interest-only loan could be a viable option.

Risks of an Interest-Only Loan

An interest-only loan is not for everyone. To qualify, you must have good credit, a solid income and, if purchasing a home, a sizeable down payment. In fact, many lenders don’t even carry this product. However, you can find this type of loan in jumbo products and through local banks.

One of the major risks in an interest-only loan is that the buyer may not be able to afford the higher payments when they take effect. To avoid this issue, you can provide a larger down payment and / or pay additional principal whenever possible to lower the balance before re-amortization occurs.

Often buyers plan to sell the property before the interest-only period has ended, with the idea that it will appreciate so they can pay off the loan and still have money for a new home. The risk in this strategy is that the house may not increase in value as expected.

Interest-only loans are generally for the more sophisticated buyer or for the investor looking at rental properties with an eye on selling in the future. For the average homebuyer, if an interest-only loan is the only way you can afford the house you want, it might be better to wait.