Demystifying Interest Only Loans with a Calculator

Interest only loans allow borrowers to pay only the interest on their loan balance for a set period of time. This results in lower monthly payments compared to fully amortized loans, making interest only loans an attractive option for some borrowers. However, these loans also come with risks that need to be fully understood before moving forward. In this article, we’ll break down how interest only loans work, who they might make sense for, and most importantly, how using an interest only loan calculator can help you make an informed decision.

What is an Interest Only Loan?

With a traditional fully amortized loan your monthly payments go towards both the loan’s principal (the amount borrowed) and interest. This gradually pays down the loan balance over the full loan term.

Interest only loans differ in that your monthly payments only cover the interest portion, not the principal You continue owing the full original loan amount until the interest only period ends

For example, say you take out a $200,000 30-year mortgage with a 5% interest rate. Here’s how the payments differ:

• Fully amortized: Your monthly payment is $1,073.64. Of this, $833.33 goes toward interest and $240.31 toward the principal in the first month. Over 360 payments, the loan is fully paid off.

• Interest only: Your monthly payment is just $833.33 for the interest only period, often 5 or 10 years. You still owe the full $200,000 after this time is up.

As you can see, interest only loans offer lower payments for a set term, followed by higher payments later. The interest only period often ranges from 3 to 10 years. After this, options include:

• Begin fully amortizing the loan for the remainder of the term

• Make a balloon payment for the full principal balance

• Refinance into a new interest only loan or fully amortized loan

Who Might Benefit from an Interest Only Loan?

Interest only loans can make sense in certain situations but they aren’t right for everyone. Consider if one of these fits your circumstances:

• Temporary cash flow issues: The lower payments may help if you’re going through a period of lower income but expect your earnings to increase substantially later. This avoids becoming house poor early on.

• Bridge loan: These loans can serve as a short-term bridge when transitioning between homes. For instance, you buy a new home before selling the old one. An interest only mortgage keeps payments manageable temporarily.

• Investment property: Investors may utilize interest only loans on rental properties to free up capital for other ventures. The rental income covers the interest payments while allowing tenants to pay down the principal over time.

• Future liquidation plan: Some borrowers plan to sell the home before the interest only period ends. In this case, the principal balance never needs to be paid back.

Outside of niche circumstances like these, interest only loans may not align well with long-term financial goals. Make sure you understand the risks before moving forward.

Risks and Downsides of Interest Only Loans

While interest only loans offer tantalizingly low payments upfront, they come with considerable risks to weigh:

• Payment shock: When the interest only period ends, your payment can skyrocket if you begin fully amortizing the loan. Prepare for this dramatic increase.

• Less equity: You aren’t paying down principal during the interest only term. This means you build equity in the home more slowly.

• Higher long-term costs: You’ll pay significantly more interest over the full loan term compared to a fully amortized loan at the same rate.

• Difficulty refinancing: If home values decline or your financial situation changes, refinancing into a new mortgage could become challenging when the term expires.

• Balloon payment: Being forced to make a large balloon payment of the entire principal is a risk if you can’t refinance or pay it off.

For these reasons, interest only loans require borrowers to meet higher qualification standards. You’ll need an excellent credit score, stable income, and substantial liquid reserves to qualify and responsibly manage the risks.

How an Interest Only Loan Calculator Can Help

If you’re considering an interest only mortgage, using an interest only loan calculator early on is strongly recommended. Unlike standard mortgage calculators, these specialized tools can show you the true costs and cash flow impact over time.

Here are some key things an interest only loan calculator reveals:

• Initial monthly payments: See exactly how much lower your payments will be compared to a fully amortized loan during the interest only period. Make sure your budget can handle higher future payments.

• Interest costs: Find out how much more total interest you’ll pay over the loan term compared to a conventional loan.

• Amortization after the interest only period: See what your new payment will be once the loan begins fully amortizing. Gauge the payment shock.

• Balloon payments: Calculate the lump sum principal balance you’ll owe if you don’t pay the loan off early or refinance.

• Prepayment impact: See how extra principal payments during the interest only period can reduce costs down the road.

Smart calculators let you model various interest only scenarios by adjusting the loan amount, interest rate, payment periods, and other variables. Experiment to find the optimal structure for your situation.

Be sure to use a calculator from a reputable source, such as the tools offered by Bankrate or mortgagecalculator.org. This ensures accuracy.

5 Key Interest Only Loan Calculator Tips

To get the most out of an interest only loan calculator, follow these tips:

1. Plug in accurate numbers: Use your actual loan amount, interest rate, loan term, and interest only period to get realistic results.

2. Model best and worst case scenarios: Calculate costs using your best and worst case interest rate assumptions. Interest only loans carry risk should rates rise later.

3. Compare amortization schemas: Contrast interest only versus fully amortized payments to quantify the short-term savings and long-term impact.

4. Project future equity: Determine how much home equity you’ll have at key milestones based on the numbers used.

5. Calculate prepayments: See how extra principal payments impact interest costs and balloon balances down the road. Even small amounts help.

Creating multiple versions allows you to stress test an interest only loan under different conditions. Use the lessons learned to structure a loan that aligns with your risk tolerance and long-term financial objectives.

Is an Interest Only Loan Right for You? Key Questions to Ask

While the calculator output is important, also ask yourself these key questions to determine if an interest only mortgage fits your situation:

• Will my income likely increase substantially in the next 5-10 years to handle higher payments later?
• Do I have a solid contingency plan before the interest only period expires?
• Am I certain I can comfortably afford the balloon payment if required?
• Can I afford to make extra principal payments during the interest only term to offset risks?
• Does an interest only mortgage align with my long-term financial goals?

Be honest about your future financial capabilities when assessing these factors. Interest only loans offer great flexibility when used prudently for the right situations. But they require a steady, rising income and solid exit strategy to avoid unwelcome surprises.

Explore Your Options Carefully

Interest only loans can be the right choice when used strategically for short-term flexibility. But make sure you go in with eyes wide open to the risks. Running the numbers with an interest only loan calculator gives you the key data needed to make an informed decision. Be sure to model different scenarios and have solid plans in place before moving forward. With the right calculator guidance, you can determine if an interest only mortgage achieves your financial goals without unwanted consequences down the road.