Interest-Only Loans: Pros and Cons

Money Trap
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With most loans, your monthly payments go toward your interest costs and your loan balance. Over time, you keep up with interest charges, and you gradually eliminate debt. But interest-only loans can work differently, resulting in lower monthly payments. Eventually, you need to pay off your loan, so it’s critical to understand the pros and cons of postponing repayment.

What Is an Interest-Only Loan?

An interest-only loan is a loan that temporarily allows you to pay only the interest costs, without requiring you to pay down your loan balance. After the interest-only period ends, which is typically five to ten years, you must begin making principal payments to pay off the debt.

Smaller payments: Monthly payments for interest-only loans tend to be lower than payments for standard amortizing loans (amortization is the process of paying down debt over time). That’s because standard loans typically include your interest cost plus some portion of your loan balance.

Calculate payments: To calculate the payment on an interest-only loan, multiply the loan balance by the interest rate. For example, if you owe $100,000 at 5 percent, your interest-only payment would be $5,000 per year or $416.67 per month.

These tools in Google Sheets can help:

  • Have  do the math for you.
  • Compare interest-only payments to .

Repayment: Interest-only payments don’t last forever. You can repay the loan balance in several ways:

  1. At some point, your loan converts to an amortizing loan with higher monthly payments. You pay principal and interest with each payment.
  2. You make a significant balloon payment at the end of the interest-only period.
  3. You pay off the loan by refinancing and getting a new loan.

Benefits of Interest-Only Loans

Interest-only mortgages and other loans are appealing because of low monthly payments. What are some popular reasons (or temptations) for choosing a small payment?

Buy a more expensive property: An interest-only loan allows you to buy a more expensive home than you would be able to afford with a standard fixed-rate mortgage. Lenders calculate how much you can borrow based (in part) on your monthly income, using a debt-to-income ratio. With lower required payments on an interest-only loan, the amount you can borrow increases significantly. If you’re confident that you can afford a more expensive property—plus you’re willing and able to take the risk that things won’t go according to plan—an interest-only loan makes it possible.

Free up cash flow: Lower payments also allow you to choose how and where you put your money. If you want, you can certainly put extra money toward your mortgage each month, more or less mirroring a standard “fully amortizing” payment. Or, you can invest the money in something else (like a business or other financial goals)—you get to choose. Most house flipping loans are interest-only in order to maximize the amount of money going toward improvements.

Keep costs low: Sometimes an interest-only payment is the only payment you can afford. You might choose an inexpensive property but still come up short on monthly funds. Interest-only loans give you an alternative to paying rent—but you can’t ignore the risks (see below).

It’s important to distinguish between true benefits and the temptation of a lower payment. Interest-only loans only work when you use them properly—as part of a strategy. It’s easier to get into trouble if you’re just going with interest-only as a way to buy more.

For example, interest-only could make sense when you have irregular income. Perhaps you earn variable bonuses or commissions instead of a steady monthly paycheck. It could work to keep your monthly obligations low and make large lump-sum payments to reduce your principal when you have extra funds. Of course, you have to actually follow through on that plan.

You can also customize your amortization schedule with an interest-only loan. In many cases, your additional payment against principal result in a lower required payment in following months (because the principal amount that you’re paying interest on decreases). Check with your lender, as some loans won’t adjust the payment (or the payment doesn’t change immediately).

Drawbacks of Interest-Only

That lower monthly payment comes at a cost. So, what do you give up when you only pay interest on your loan?

No equity: You don’t build equity in your home with an interest-only mortgage. You can build equity if you make extra payments, but the loan does not encourage that by design. You’ll have a harder time using home equity loans in the future if you ever need cash for upgrades.

Underwater risk: Paying down your loan balance is helpful for numerous reasons. One of them is reducing your risk when it comes time to sell. If your home loses value after you buy, it’s possible that you’ll owe more on the home than you can sell it for (known as being upside-down or underwater). If that happens, you’ll have to write a large check just to sell your home.

Putting off the inevitable: You’re going to have to pay off the loan someday, and interest-only loans make that day more difficult. We like to believe that we’ll be in a better position in the future, but it’s wise to only buy what you can comfortably afford now.

If you just pay interest, you’ll owe exactly the same amount of money in ten years that you owe now—you’re just servicing a debt instead of paying it off or improving your balance sheet.

Example: Assume you buy a home for $300,000, and you borrow 80 percent (or $240,000). If you make interest-only payments, you’ll owe $240,000 on that home (until the interest-only period ends). If the home loses value and is worth only $280,000 when you sell it, you won’t get your full $60,000 from the down payment back. If the price drops below $240,000 when you sell, you’ll have to pay out-of-pocket to repay your lender and get the lien on your home removed.

You have to pay your loan off one way or another. Usually, you end up selling the home or refinancing the mortgage to pay off an interest-only loan. If you end up keeping the loan and the house, you’ll eventually have to start paying principal with each monthly payment. Again, this conversion might happen after ten years. Your loan agreement explains exactly when the interest-only period ends and what happens next.

Interest-only loans aren’t necessarily bad. But they’re often used for the wrong reasons. If you’ve got a sound strategy for alternative uses for the extra money (and a plan for getting rid of the debt), then they can work well. Choosing an interest-only loan for the sole purpose of buying a more expensive home is a risky approach.