Understanding The Interest-Only Loan
Understanding the Interest-Only LoanBy Peggy DeVilbiss, Loan Officer for Liberty Home Loans Many lenders today offer “interest-only” loans in addition to the standard “fully amortized” loan. With a fully amortized loan, you pay both principal and interest (P&I) each month, and after a period of time the loan is paid off in full. With an interest-only loan, your monthly payments only cover the interest due on the loan. There is no payment made toward the principal, and therefore there is no reduction in the original loan amount.For example, if you borrow $100,000, and you pay only the interest each month, then the principal amount of $100,000 is not reduced. After any period of time of payments, whether for one year, five years, or ten years, you will still owe $100,000.A common interest-only loan lasts for 30 years, with interest-only payments allowed for just the first 10 years. Then the loan automatically converts to a fully amortized loan that will be paid off in full over the next 20 years.Interest-only loans have advantages and disadvantages.Advantages of interest-only loans:1. Allow a lower monthly payment.2. Enable a homebuyer to purchase a more expensive home.3. Offer financial flexibility for people with cash-flow cycles. The borrower can pay toward principal as cash flow allows higher payments.4. Give borrower more control over money management. Borrower has contractual obligation for a lower amount, but can pay down the principal at any time.Disadvantages of interest-only loans:1. There is no equity gained through the principal reduction of a fully amortized loan. Increased equity is totally dependent on the appreciation of the value of the property. If the market declines or softens substantially, the borrower could face a financial setback or difficulty.2. There is no increase in wealth that normally occurs through reduction in debt.3. When loan converts to a fully-amortized loan, it is usually for a shorter term than 30 years, and therefore the monthly payments are higher than they would have been if amortized over 30 years.Most people who benefit from the interest-only loans do the following:1. Either refinance or sell the property within the first five-year period.2. Have a specific use for the “savings” that increases their wealth position.3. Have a plan that utilizes the “savings” advantageously, such as property improvements, savings, paying off consumer debt, purchasing another property in an appreciating market, etc. 4. Don’t just spend the extra money on depreciating consumer items.Is the interest-only loan for you? It depends on your goals, needs and timeframe.Talk with a mortgage broker about your specific plans. The mortgage professional will help you learn the different options available, and which ones will be most advantageous for you. The interest-only loan may fit you perfectly.Talk with a mortgage broker about your specific plans. The mortgage professional will help you learn the different options available, and which ones will be most advantageous for you. The interest-only loan may fit you perfectly.
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