Interest-Only Loans: What to Know

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|10 min read

Interest-only loans are a type of loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period. At the end of the interest-only term, the borrower must repay the entire principal balance in a lump sum.

Most homebuyers won’t consider this type of loan because it often has a specific purpose, such as when flipping houses. In this article, we will discuss everything you need to know about interest-only loans so that you can make an informed decision if this is the right type of loan for your home buying needs.

What is an Interest-Only Loan?

As we noted earlier, it is a specific type of loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period.

The main reason why people get this type of loan is that they want to keep their monthly payments low. It’s important to remember that you will still owe the entire loan amount at the end of the interest-only term.

How Does it Work?

The borrower only pays the interest on the loan for a fixed period of time, usually 3-10 years, sometimes longer, sometimes shorter. After that, the borrower must start paying off the principal balance in addition to the interest.

They are structured similarly to an adjustable-rate mortgage (ARM) in that the interest rate can rise or fall after the initial fixed period. But with an interest-only loan, payments are only required to cover the interest for a set period of time.

This type of loan often has a balloon payment at the end of the interest-only term. That means that you’ll need to come up with a lump sum payment to pay off the entire loan balance.

If you don’t have the money to do that, you may be able to refinance the loan or sell the property to get the money. Keep in mind that if interest rates have gone up, your monthly payments will be higher when you start paying off the principal balance.

Can I Get a Fixed-Rate Interest-Only Loan?

Yes, but they are far less common. With a fixed-rate interest-only loan, your interest rate is locked in for the entire term of the loan, which offers some stability. Under a 30-year fixed-rate structure, you may only pay interest-only payments for the first 10 years, for example.

After that term has expired, your loan would jump over the remaining 20 years, meaning that your monthly payments would increase as you pay off both the interest and principal balance.

What are the Benefits?

The biggest benefit is that your monthly payments are lower during the interest-only term. That can free up cash flow so you can save money or pay down other debts.

It can also help you qualify for a loan that you might not otherwise be able to get. Lenders look at your debt-to-income ratio when considering you for a loan. If your monthly payments are lower, that can help you qualify for a bigger loan.

What are the Risks?

The biggest risk is that you’ll owe a large lump sum at the end of the loan term if you don’t have the money to pay it off. That could force you to sell the property or put it up as collateral for another loan.

Another risk is that you could end up paying more interest over the life of the loan if interest rates go up after you get the loan. That’s because you’ll only be paying interest on the loan for a fixed period of time.

If rates go up, you’ll still be paying the same monthly payment, but more of that payment will go towards interest rather than principal. Finally, you’re going to find it difficult to shop around and find the best rates since many lenders do not offer this type of loan.

Who Should Get an Interest-Only Loan?

This type of loan is usually best for people who are confident that their income will increase over time. That’s because the payments are lower during the interest-only term, but they will go up when you start paying off the principal balance.

It can also be a good option if you’re buying an investment property that you plan to sell after a few years. That way, you can keep your monthly payments low while you wait for the property to appreciate in value.

Just remember that you’ll need to have the money to pay off the loan when the interest-only term expires.

What Do I Need to Qualify?

After the housing crisis of 2008, adjustable-rate and interest-only mortgages fell under increased scrutiny. Many lenders are hesitant to offer these types of loans now.

If you’re able to find a lender who’s willing to give you an interest-only loan, you’ll need to have an excellent credit score, a steady income, a higher down payment, and likely some cash reserves. You’ll also need to show that you have the cash flow to make the higher payments when the interest-only term expires.

Interest-only loans can be a good option if you’re buying an investment property or you’re confident that your income will increase over time. Just remember that there are risks involved, and you’ll need to have the money to pay off the loan when the interest-only term expires.

Summing It Up

If you’re thinking of getting an interest-only loan, make sure to talk to a qualified financial advisor first. They can help you understand the risks and benefits of this type of loan and make sure it’s the right choice for you.

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