Demystifying Interest-Only Loans: How They Work and When They Make Sense

Interest-only loans have developed a bad reputation over the years, often viewed as a risky mortgage product that fueled the housing bubble and subsequent crash However, the reality is that interest-only loans, when used responsibly, can be an effective tool for certain borrowers’ situations In this comprehensive guide, we’ll break down exactly how interest-only loans work, the pros and cons, and when they potentially make sense for borrowers.

What is an Interest-Only Loan?

With an interest-only mortgage, the borrower pays only the interest on the loan for an initial period of time, typically 5-10 years. During this interest-only period, the loan balance (principal) remains unchanged.

After the interest-only period ends, the loan converts to a standard amortizing mortgage where each payment covers interest plus part of the principal. At this point, the principal starts to be paid down over the remaining loan term.

Key Features

• Lower monthly payments during interest-only period
• Principal balance stays the same initially
• Converts to fully amortized loan later
• Typically adjustable-rate mortgages (ARMs)

Interest-only loans differ from negative amortization loans where unpaid interest gets added to the balance. With interest-only loans it’s required that at least the interest is paid so the balance never grows.

Common Uses for Interest-Only Loans

There are a few situations where an interest-only mortgage can make financial sense:

1. Short-term savings: The lower payments free up cash flow for other goals in the short term. This works best if you know your income will jump substantially after 1-5 years.

2. Buying investment properties: The interest write-off benefits investors, and lower payments make it feasible to purchase multiple properties.

3. Future lump-sum repayment: You have money tied up somewhere that will become available soon to pay down the principal.

4. Bridge loan: An interest-only mortgage can serve as a temporary bridge when transitioning between homes.

Utilized properly, an interest-only loan can provide temporary payment relief or flexibility. But it’s critical to have a plan for what happens when the interest-only period expires.

How Payments Work on Interest-Only Loans

Since interest-only loans defer principal payments for a set period, the payment calculation is different:

Interest-only payment formula:

Monthly payment = Principal balance x Interest rate / 12

For example:

Loan amount: $200,000
Interest rate: 5%
Monthly payment on 5-year interest-only loan = $200,000 x 0.05/12 = $833

As you can see, payments are lower because no principal is included. But once the interest-only period ends, payments will jump significantly to start covering the principal too.

The Risks of Interest-Only Loans

Interest-only loans come with sizable risks that borrowers should carefully consider:

• Payment shock: When the interest-only period expires, payments spike to account for principal paydown. This may make the loan unaffordable.

• Negative amortization risk: If an adjustable-rate mortgage, payments could fail to cover all interest due when rates rise. This causes the balance to grow.

• No equity buildup: With the principal untouched for years, no equity is built initially. This makes it harder to refinance or tap home equity.

• Chance of default: Lower monthly payments can entice borrowers to take on more debt than they can truly manage long-term.

• Prepayment penalties: Many interest-only loans have penalties for paying off the balance early.

While these risks can be managed with proper planning, interest-only loans are riskier than conventional mortgages. They are best utilized as a temporary, strategic option by knowledgeable borrowers.

Alternatives to Interest-Only Mortgages

Other options may meet short-term cash flow needs with less risk than interest-only loans:

Mortgage Recast: One way to reduce mortgage payments is to recast the loan, meaning re-amortize the remaining balance over the remaining term. This often costs a few hundred dollars but avoids interest-only risks.

Home Equity Loan/Line of Credit: Tapping accumulated home equity via a HELOC or home equity loan allows access to cash without changing the primary mortgage.

Cash-Out Refinance: Refinancing into a larger mortgage and taking cash out is another way to tap equity for other financial needs.

Biweekly Payments: Making half mortgage payments every other week reduces amortization period and interest paid over the loan.

Key Takeaways on Interest-Only Mortgages

• Interest-only loans allow paying only interest for a set period before the loan becomes amortized.

• When used strategically, they provide short-term payment flexibility and cash flow benefits.

• Significant risks include payment shock, negative amortization potential, and lack of equity buildup.

• Strict criteria for qualification make interest-only loans much rarer in the post-housing crisis mortgage market.

• Safer alternatives exist for most situations where interest-only loans would be considered.

While interest-only mortgages aren’t inherently dangerous products, they are high risk and require ample expertise and planning to use effectively. For the majority of homebuyers, conventional amortizing loans tend to be the best choice. But in the right circumstances, interest-only loans can be reasonable options when utilized very carefully.