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Interest Only Loans

How Interest Only Loans Work

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Interest only loans allow you to pay interest only. In contrast, a traditional amortizing mortgage requires you to pay some interest and some principal in each monthly payment. By eliminating the need to pay principal, an interest only loan option keeps your monthly payments lower. This page covers how fixed rate interest only loans work.

Benefits of Interest Only Loans

There are a variety of reasons you might want to have a lower monthly payment:

  • Buy a more expensive home with a smaller monthly payment
  • To free up money that you have a better use for
  • To keep your monthly obligations smaller
  • To make your own custom amortization schedule

Interest only loans can work very well when you intend to use them properly. For example, your income might be variable (because of bonuses or commission based work). In this case, you might save on your monthly payment (by paying interest only) and make larger payments against the principal when you have extra money. Of course, you have to actually make those larger payments.

You can also customize your amortization schedule with an interest only loan. See How Amortization Works for details on how amortization affects on your mortgage. In many cases, your additional payment against principal will result in a lower required payment in following months (because the principal amount that you’re paying interest on has decreased).

Pitfalls of Interest Only Loans

Interest only loans also have some drawbacks. The main problem is that you don’t build any equity in your home. This can be a problem because:

  • You aren’t building wealth for yourself
  • If your home loses value you may have to write a check to sell it
  • You won’t increase equity that you could borrow against later with a second mortgage
  • You’ll have to do something to pay the mortgage sooner or later
Because you’re only paying interest, you don’t reduce the balance on your loan. Instead, you’re just servicing a debt – or “treading water” – if you only make the required interest payments.

Imagine that you buy a home for $300,000, and you borrow 80% (or $240,000). If you make interest only payments, you’ll always owe $240,000 on that home. 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 unload the house.

Of course, you have to pay the money back at some point. Usually, you end up selling the home or refinancing the mortgage to pay off your interest only loan. If you end up keeping the loan, the bank might make you pay principal back after 10 years or so. Your lender should explain when and how this occurs.

Interest Only Loan Calculations

You can see how your payments will differ with an interest only loan calculator. Compare the payment on your interest only loan to the payments required for an amortizing loan:

An interest only loan may be right for you. Just make sure you understand the pitfalls before you decide to pay interest only. Choosing an interest only loan for the sole purpose of buying a more expensive home is not a good idea.
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