What are interest-only loans? How are they structured and who are they right for? How do you avoid common mistakes people make when choosing interest-only loans?
Loans with the option of paying only the interest every month are called interest-only loans. These loans allow you to pay on the principal balance only when you want to or when it is convenient for you.
Most interest-only (IO) loans carry this option to pay the interest only for a limited amount of time, usually from 5 to 10 years. The remaining principal balance comes due at the end of the term.
IO loans can be a good choice for borrowers whose incomes tend to fluctuate from month to month.
However, this aspect of IO loans can be a pitfall for borrowers who are not disciplined enough to pay on the principal when they are not required to do so..
Borrowers who expect to see an increase in their income during the term of the loan should consider loans with IO options. First time homebuyers can also benefit from IO loans, if they expect to upgrade from their starter home to a bigger home soon.
Another advantage of interest-only loans is that they require lower initial payments, which means borrowers can qualify for larger loan amounts than loans without interest-only options.
Is your home going to be your top priority investment, or do you want more cash to direct to other investments that offer higher returns? If you invest in stocks or your own business, and interest-only loan might be the right option for you. Just make sure your investments are yielding a higher return than the interest rate on your IO loan.
Are you expecting to resell your home during the term of the IO loan for a profit? Is the market you are looking to buy in rapidly appreciating? If so, an interest-only loan might be the right choice for you.
Interest only loans do carry risks, and borrowers must understand these risks if they are to take advantage of IO options. What if you do not see the increase in income you expected? What if you cannot sell your home later for a profit, or what if the market does not appreciate as much as you expected? What if the market depreciates?
There are dishonest lenders out there, and they often deceive borrowers when it comes to interest-only loans. One common deception is that lenders lead borrowers to believe that the interest rate on an IO loan is lower than the interest rate on loans without an interest-only option. This is not the case. IO loans carry higher risks for the lender, so they always carry higher interest rates.
Dishonest lenders sometimes deceive borrowers into thinking that they can avoid buying mortgage insurance by choosing an interest-only loan. Again, because IO loans are high-risk for the lender, the borrower is always required to carry mortgage insurance.
Comparing different types of loans is the most important step in choosing the best loan for you. Every situation is unique, and understanding how loans are structured will help you make the right decision. Identify your goals, and you will be able to identify the right loan to help you reach them.
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