If you are shopping for a house or refinancing, you’ve probably seen ads for interest-only loans. While this type of loan is beneficial for some homebuyers, other homebuyers might regret the decision to take out an interest-only loan.
Interest-only (IO) loans are structured so that the borrower pays the interest every month. The borrower is not required to pay on the principal balance, although the borrower does have that option.
Usually, this option to pay interest only lasts for a limited period of time, typically between 5 and 10 years.
This type of loan can benefit borrowers who have fluctuating incomes, or who expect to see an increase in their income sometime in the near future. Because the borrower has the option of paying on the principal when it is convenient, some borrowers feel more comfortable with IO loans, rather than other types of loans that require payments on the principal each month.
However, if the borrower does not pay down the principal at all, then the entire balance will be due at the end of the term. With IO loans, any unpaid principal must be paid or refinanced when the term is up.
Homebuyers looking for a “starter home” often choose IO loans, because they expect an increase in income to upgrade into a second home sometime soon.
For homebuyers who wish to maximize their options, IO loans can be helpful because they require a lower initial payment, which means the borrower can usually qualify for a bigger loan.
Borrowers with other high-return investments can also profit from interest-only loans, as the increased monthly cash flow allows them to put money into stocks, or into their own business. When the other investments earn more interest than the interest rate on the IO loan, this is a profitable option.
Buyers looking for real estate in rapidly appreciating markets might benefit from interest-only loans as well. If you expect to “flip” your home – that is, resell it in the near future at a profit – an IO loan might be the smartest choice.
Interest-only loans do carry risks for the borrower. What if the expected higher income never comes? What if you expect to resell your house, but cannot find a buyer or a profitable offer? And not all borrowers can bring themselves to pay down the principal when they are not required to do so.
With predatory lending on the rise, be wary of lenders who offer interest-only loans at a lower interest rate than other types of loans. IO loans typically carry a higher interest rate than loans without an interest-only option. Be suspicious of low rates on interest only loans.
Another common deception is that IO loans allow the borrower to avoid paying for mortgage insurance. This is never the case. Because IO loans are riskier for the lender than other loans, lenders will require mortgage insurance on the loan.
Every situation is unique, and the key to making a sound financial decision when it comes to comparing loans is to understand your options. There are many types of mortgage loans to choose from, and one of them is surely best for you. Understanding how the loans work is the first step in choosing the right one.
