Signing for an interest only loan.

Interest Only Loans

Considering an interest only loan? They are not as popular as they once were but they are making a comeback. So, is an interest only loan the right way to go. Learn the basics and find out.

What is an interest only loan?

With this type of loan, the borrower only pays the interest on the loan for a set term. Your payment will be made up of just your interest and your escrow payment. There will be no monthly installments paid toward principal. The term of the interest only period is usually from 5 to 10 year. When this period is up, the loan is restructured so that you begin paying down the principle. The result, a low payment for the first portion of the loan and a larger payment on the second part. During the beginning period, you can and should make payments on the principal as funds allow. If you decide not to do so, the loan balance will remain unchanged during the first term of the loan.

How much cheaper is an interest only loan?

They can give you a huge monthly discount over a conventional loan. On a $300,000 mortgage the difference in the payment can be $400 to $500. For many people, an extra $500 dollars a month can be better spent elsewhere. On the flip side, when the interest free term is over, the loan payment would be higher than what it would have been if you originally used a 30 year conventional.

How do you qualify for an interest only loan?

It is not as easy as you think. It used to be that you only had to qualify for the initial interest free option. This caused a lot of mortgage issues. Now, the borrower must qualify for the highest possible payment. So, you will need to qualify for what the payment will be after the interest free term is over. In addition, lenders will typically require a much higher credit score, over 700 and a larger down payment. Expect to put at least 10% down on your home.

Who should consider an interest only loan?

The main benefit of an interest only loan is the fact that the fixed required payment will be lower. This makes it ideal for those who’s income fluctuates throughout the year. Salespeople, the self employed, seasonal workers and those who’s income just fluctuates in general might find this type of loan useful. They can have a low payment throughout most of the year and then make payments on the principal when they get bonuses or their income spikes.

Another type of borrower who might find an interest only loan useful is someone who expects to make much more money in the near future. If you are just starting your career, for example, it might be useful to have a low payment for the first five years of the loan. After the first five years are over, the loan will go up at the same time as their salary. It can allow you to buy more house now, knowing that you will be able to afford it fully in the future.

If you have an existing mortgage and are trying to sell your home, an interest only loan might appeal to you. It would allow you to keep your payments low while you are carrying both mortgages. Then, when you sell your home, you can make a large payment towards the principal of your new home.

Finally, you have the person who is willing to take a bit of a risk. If you know that you are going to be selling your home in a few years and you expect the homes in your area to increase greatly it might be a good choice. You can make interest only payments and then sell your home in 3 or 4 years. At that time, you could walk with a nice amount of money that you can put down on a new home.

Who should NOT consider an interest only loan?

This loan is not for everyone and it comes with certain risks. If you feel that the home will not appreciate, the loan should be avoided. Since no principal is being paid off, if the home did not gain value you could find that you are unable to get out from under it. Even if the value of the home stayed the same, if you sold it, you would have to come to the table with money to pay selling commissions and fees. If it lost value, you would be in even more trouble.

Also, if you did not expect your income to increase, an interest only loan might be the wrong choice. The payment, after the interest free term, will go up. If you end up not being able to afford the payment you would have to sell the home or be in risk of losing it.

Finally, if you are not disciplined, this loan might not be right. When the extra money comes in, you need to use it to pay down the principal if you intend to keep the home past the initial loan term. It is tempting to take the money and spend it frivolously instead of doing the responsible thing.

In general, interest only loans are a risk. If you are not prepared to take on this risk, stick to a conventional mortgage.

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James Car is a finance, loan and budget expert based in the United States. After attending Brookhaven college, he went on to become a successful entrepreneur. He now enjoys writing articles that help people save and make the most of their money.