Interest Only Loans
“Interest only” products are an easy way to save money and a very popular alternative to traditional fixed rates but they are not without risk. An “Interest Only” loan can offer consumers greater purchasing power, increased cash flow and a number of other benefits which are listed later in this article.
First let us start with a quick explanation of how the product works. With Interest only loans the borrower has the flexibility of paying only the interest due on the mortgage. Most of these products allow you to pay extra if you choose.
The positive aspects of these loans are as follows:
- They work well for borrowers that are restricted by a tight budget, and the savings can be as much as $300-400 per month!
- Interest Only loan can allow you to qualify for a bigger home. If the underwriter considers only the “Interest Only” payment, you may be able to upgrade to a nicer or larger home.
- This type of loan works well for people who only want to stay in a home for a just a few years. During the first couple of years with a conventional 30 yr mortgage, most of your mortgage payment is being applied directly to the interest of the loan. If you want to stay in the house for only 3-5 years, an “Interest Only” loan may be the right loan for you. You can receive a lower payment and have almost the same principal balance as the borrower who chose a 30 year, conventional mortgage if you choose to sell in 3-5 years.
- You want to buy a very expensive home. Most people who buy very expensive home have no desire to pay off their home completely, and the rate of appreciation on the house is usually very good. An “Interest Only” loan allows these borrowers to deduct their interest payments, and the money they save can be directed to other investments.
- You want to buy a rental property. The lower payment can help improve cash flow on a rental property.
As with every loan program, with positives there are always negatives.
- You are not paying down your principal on your mortgage. If your property doesn’t appreciate in value over those 3-5 years, you may even have to pay money if you choose to sell the home. While the likelihood of this happening is high, it is a risk that must be considered when thinking about using Interest Only loans.
- Most “Interest Only” products have a specified term. For example, on most 30 year fixed “Interest Only” loans, most lenders allow interest payments for 10 years, and then you must repay the loan during the last 20 years. This loan now must be amortized over a 20 year period, and this will carry a higher payment than a 30 year fixed mortgage. These loans may be a good option for you as a borrower, but each person’s situation is unique.
- Lastly, when in a period of incredibly low fixed rates “Interest Only” products will be very attractive. But, if you are planning on staying in your home for an extended period of time, you may want to consider a traditional fixed product.
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Determining If An Interest Free Loan Is Right For You
Purchasing a house is an exciting process and one of the largest emotional and financial investments you are ever going to make. Emotionally, you are investing in your family and your future. You are not just buying a house, you’re buying your family’s home. Financially, buying a house is one of the soundest investments a person can make. Though the housing market can go up and down, overall if you make good choices, you will never lose money by investing in a house. And, in the end, your home will be the best investment of your life.
Purchasing a house however, is not as easy as just finding one that you like, signing a few papers and getting the keys. There are numerous aspects involved in purchasing a house. Financial records, credit checks, down payments, realtors, lenders, and mortgages are all involved in buying a home. Though it’s an exciting process it is also slow, complex, and often confusing. One of the most confusing parts is determining what form of loan is best for you.
The most common mortgages that people choose from are fixed rate mortgages and adjustable rate mortgages. Fixed rate mortgages have the same interest rate for the entirety of the loan. Adjustable rate mortgages have a period where the interest rate is fixed and then it changes to an adjustable interest rate that can go up or down. While these are the most common, they are not the only form of loans people can get to purchase a house. Before the housing crisis of 2008 a common loan was an interest only loan and though they stopped being used they have begun to make a small comeback.
What is an Interest Only Loan?
An interest only loan is a loan where the borrower is only required to pay on the interest of the loan for a set amount of time, usually five to ten years. After that time, they must begin paying on the principle or balance of the loan to decrease the debt owed along with paying on the interest.
Normal loan payments are calculated by taking a portion of the interest and a portion of the debt and adding them together giving you the monthly payment. Interest only loans however, only consider the interest owed, which means there is a lower monthly payment. Another reason the payments are going to be lower is because the interest is going to be less than the actual debt. This means that instead of paying down a $100,000 loan with a 5% interest rate, you are simply paying the 5% interest rate, which in this case it would be $5,000 a year.
Advantages and Disadvantages of Interest Only Loans
It is very easy to get caught up thinking about how nice it would be to have lower monthly house payments. In fact, simply based on the general definition of an interest only loan you must wonder why everyone doesn’t opt for one. But it is important to remember what the advantages are versus what the temptations are of an interest only loan. These loans must be used properly and not simply for a smaller monthly payment. Plus, just like all loans, there are also disadvantages that must be considered.
- Buy a more expensive property—Loan amounts are partially determined by your monthly debt-to-income ratio. Since interest only loans have lower monthly payments, they allow you to borrow more money for a more expensive property.
- Free up cash flow—Lower monthly payments also give you more money each month to put where you want. Though it can be used to put extra money towards your mortgage it can also be invested into other opportunities to help you earn money.
- Low costs—At times an interest only loan may be all you can afford at that time. It allows you an avenue other than paying rent.
- No equity—You cannot build equity with an interest only loan because you are not paying on the debt of the loan.
- Upside down risk—The housing market has its ups and downs which means that your home could lose value after you buy it. If the value decreases too much, then there is a possibility that you will owe more than you can it sell for.
- Putting off the inevitable—Sooner or later you’re going to have to pay off the loan. It’s nice to think that you will be in a better position later down the road, but that is not a guarantee. It’s much better to buy what you can afford now then hope for a more prosperous future.
Who Could Benefit from an Interest Only Loan?
The advantages and disadvantages of interest only loans are clear cut. However, it is not clear who would benefit from such a specific loan. But, U.S. News and World Report provided a list of borrowers that could benefit from interest only loans.
- Those concerned with cutting monthly payments—Those that rather lower their monthly payment then pay off their loan, such as people that plan to move or downsize before the interest only period ends.
- Those with a variable flow of income—If you have a short-term cash flow problem then an interest only loan could be right for you. An example would be someone that owns a seasonal business.
- New homeowners that are trying to sell their other property—Once they can sell their other property, they can use that money to make a large lump sum payment on the principle.
- High-level investors and borrowers—An interest only loan provides flexibility to someone that may want to put money into other investments. For example, they could use their additional money for the stock market and then use their earnings to pay a large sum towards the principle at the end of the year.
Advantages and Disadvantages of Interest Only Loans
Interest only loans are useful in areas with increasing home prices. For example, Arizona home values have gone up 8% over the last year and are expected to go up another 3.8% over the coming year. Therefore, if you are planning on buying a home in one of these areas, you may want to consider an interest only loan.
- Sun City West
- Litchfield Park
- Queen Creek
- Paradise Valley
- Casa Blanca
- Chandler Heights
- Sun Lakes
- Cave Creek