An interest only loan is a personal or home loan for which the borrower will only make payments on the interest accrued by the principal, saving the capital amount for future payment. At the end of the term – sometimes several years later – the borrower has the option of payment the capital off in one lump sum or refinancing to another loan.
In most cases, lenders require that borrowers pay back an interest only loan at the end of the term, requiring the remission of a large sum of cash. No payments are made toward the principal during the term, which means that the capital left will be the amount originally borrowed. Typically, interest only loans are made over the course of one to five years, though some interest only loans can be in excess of ten or twenty years. If another loan is taken out against the principal, the balance will be amortized for the remaining term.
The most common circumstance in which interest only loans are sought is when an investor purchases a property with the intent of re-selling it quickly for a profit. Since the investor is required to only pay on the interest, he will be less out-of-pocket when the property is finally sold.
An individual or family can also benefit from an interest only mortgage loan if they plan to stay in the house for only a few years. This is a similar situation to that of a real estate investor; they will spend less money on the mortgage loan repayments than if they had taken out an interest and principal loan.
Unfortunately, however, problems can occur when it comes to interest only payments. One of the largest complications is when an investor or individual experiences unforeseen expenses, and is not able to make good on the loan once the term has expired. Similarly, it can be difficult to refinance such a loan if you are unable to make the principal payment.
Advantages of an Interest Only Loan:
#1. Lower Monthly Payments – You will have much lower payments when you are repaying only on the interest, and it will be easier to sell the property for a profit if the loan is for a mortgage on a house.
#2. Fixed Interest – Most interest only loans come with a fixed interest rate versus an ARM (Adjustable Rate Mortgage) so you will be able to foresee what your loan payments will be each month.
Interest Only Loan Disadvantages:
#1. Market Variables – if the market falls and your property is devalued, you will be forced to sell and take it as a loss.
#2. Unexpected Expenses – if you end up having to spend your money on something else, you could wind up in a bind at the end of the term.