Interest-Only Loan Programs

How Does an Interest Only Loan Work?

An interest-only loan has a repayment period (usually between five and ten years) under which only interest is paid. Once the interest-only repayment period has passed, the borrower will begin paying down principal and interest. As an example, a borrower might acquire an interest-only mortgage under a 30-year term. For the first 10 years, the borrower pays only interest. For the next 20 years, the mortgage operates as usual: both interest and principal are paid down.

On a practical basis, an interest-only loan has a lower upfront payment but a higher payment later on. When the borrower is only paying interest, they have a low mortgage payment. But once the borrower begins paying the principle, they must pay the principal down faster than they otherwise would. In the above example, the borrower is paying a 30-year loan in only 20 years.

What Are the Advantages of an Interest Only Loan?

An interest-only loan is ideal for those who believe that their earning potential will be increasing in the coming years. Since an interest-only loan starts with low payments and then increases the payments later on, it can be a good way for someone who doesn’t otherwise qualify for a loan to get into the market. Interest-only loans may also make sense in areas with rapidly increasing real estate prices. In these markets, it’s often best for a borrower to get into the market as quickly as possible.

Under an interest-only loan, you still have the option of paying money towards the principle of the loan. If you do pay money towards the principle of the loan on a scheduled basis, you can essentially turn an interest-only loan into a conventional loan. Thus, an interest-only loan can afford you some level of flexibility, letting you pay off your loan at your own speed.

It’s possible to either sell a home or refinance the home before your interest-only period ends. If your home has appreciated significantly in value, selling your home can net you a profit, even if you haven’t been able to pay any of the principal down. If your credit score and debt-to-income picture have improved, you may also be able to refinance into more favorable loan terms.

What Are the Disadvantages of an Interest Only Loan?

During the first five to ten years, the buyer will not be paying down principal for their loan. They won’t be building equity very quickly — though they may still build some equity if the property’s value increases substantially. When the interest-only period ends, the buyer may find themselves unable to pay the higher mortgage amount. Due to this, it’s often recommended that borrowers not acquire an interest-only loan unless they would otherwise qualify for a conventional loan. Since interest-only loans are higher risk than conventional loans, interest rates are usually higher.

If your interest-only loan is not a fixed-rate loan, but instead an ARM, your rates could go up substantially. You could find your mortgage payment doubling or even tripling once your interest-only period ends. This is why interest-only loans are often considered high risk: at this stage, it’s sometimes beneficial for the home buyer to walk away from the loan.

Interest Only Loan Programs

Most interest-only loan programs will have similar credit requirements and debt-to-income requirements as conventional loans. It’s easier to qualify for interest-only loans because the upfront payments are more affordable: the borrower only needs to qualify for these reduced payments. Interest-only loan programs will vary based on the interest repayment period and will either be a fixed-rate or variable rate. It’s not as easy to qualify for interest-only loans as it used to be, because interest-only loans are often blamed for having a part in the previous housing crisis.

An interest-only loan is an option for a home buyer who cannot otherwise qualify for a conventional loan or a home buyer who wants more flexibility regarding how they want to pay their loan. This is a higher risk loan product because payments can go up dramatically at the end of the interest-only period. But in areas with particularly hot real estate markets, an interest-only loan can allow a borrower to get their foot in the door and start building their equity.