If you have the option of paying only the interest
every month on your loan it is called an interest-only
loan (or mortgage). This type of loan allows you to
pay on the principal balance only when you want to or
when it is convenient for you.
Most interest-only loans or mortgages limit the option
to pay the interest only for a specific amount of time,
(you can't put off paying the principal forever) usually
from 5 to 10 years. The remaining principal balance
comes due at the end of that term.
Interest-only mortgages may be a good choice for certain
borrowers like those whose incomes fluctuate from
month to month.
However, this feature of Interest-only loans
and mortgages can be either a benefit or a pitfall for
borrowers. You must be disciplined enough to pay
the principal even though you are not required to do
so.
For those borrowers who expect their income to increase
during the term of the loan may consider loans with
Interest Only options but it is often difficult to start
paying the principle if you are not in the habit of
doing so.
First time homebuyers may also benefit from Interest
Only loans, if they expect to upgrade from their starter
home to a bigger home soon. [But they will not have
built up as much equity to use toward the second home]
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.[But this can also be the major
disadvantage by allowing you to get in over your head
too easily. ]
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 Interest Only loan.
Are you expecting
to resell your home during the term of the Interest
Only mortgage 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 higher risks, and borrowers must
understand these risks.
- 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.
Because the monthly payment is less, a common deception is that the interest rate on an Interest Only mortgage is lower than the interest rate on loans without an interest-only option.
This is not the case. Interest Only 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 Interest
Only loans are high-risk for the lender, the borrower
is always required to carry mortgage insurance.
[Note: Higher Risk for the Lender also means Higher
risk for you!- editor]
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.
For more information on other types of loans see our article on Bi-Weekly Mortgages.
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