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

Interest-only loans are a unique type of financing where you only pay the interest charges and don’t pay down the principal balance during a set period. With the low monthly payments, interest-only loans seem tempting. But they also come with risks that borrowers should understand.

Below we’ll explore what interest-only loans are, how they work, their pros and cons, and when they potentially make financial sense for borrowers.

What Are Interest-Only Loans?

With a typical fully amortized loan, part of your payment goes toward interest charges and part goes toward reducing the principal balance. Over the life of the loan, the principal is slowly paid down until it reaches zero.

Interest-only loans flip this structure for a set period of time. During the interest-only period, your payments only cover the monthly interest charges. The principal balance remains untouched. It’s not until after the interest-only period ends that your payments start going toward the principal.

For example

• You take out a 30-year mortgage with a 5-year interest-only period
• For the first 5 years, your monthly payments only cover interest
• In year 6, payments toward the principal kick in
• By year 30, the principal and interest are fully paid off

This structure results in much lower monthly payments during the interest-only period since you’re not paying down principal. But once the interest-only period ends, payments spike because principal paydown gets added to the monthly dues.

When Are Interest-Only Loans Used?

Interest-only loans are common for adjustable-rate mortgages (ARMs). The interest-only period often aligns with the ARM’s initial fixed-rate period before the interest rate starts adjusting. This helps keep payments affordable when rates are stable.

Interest-only loans also pop up for:

• Short-term bridge loans needing quick financing
• Investment properties when cash flow is a concern
• Business lines of credit providing working capital
• Certain niche home loan programs

Additionally, borrowers sometimes use interest-only home equity loans or lines of credit (HELOCs) to consolidate higher-interest debt into a lower monthly payment.

The Pros of Interest-Only Loans

Lower Monthly Payments

Since you’re not paying down principal, interest-only loan payments are lower, reducing cash flow strain. This can make it easier to qualify for a larger loan amount than with a fully amortized loan. The lower payments provide flexibility to use extra funds for other financial priorities.

Tax Benefits for Investment Properties

For real estate investors, interest-only payments are fully tax deductible. Avoiding principal paydown can provide greater leverage and increase cash-on-cash returns.

Short-Term Solutions

For short-term loans like bridge financing, paying only interest while needing the capital can be beneficial. The same may apply when needing a HELOC for a year or two to cover an expense.

Payment Flexibility

Some interest-only loans allow flexible payments, like interest-only for a set time then switching to fully amortized payments. This caters the loan to your needs.

The Cons of Interest-Only Loans

Balloon Payments

Because the principal doesn’t pay down, you’re hit with a giant balloon payment at the end to cover the full principal. You need to be certain you can afford this payment when it comes due.

Extension Risk

Some lenders will let borrowers extend the interest-only period to delay the balloon payment. But this racks up more interest charges and generates no equity until principal paydown begins.

No Equity Builds

You don’t build any equity with an interest-only loan until after the interest-only period when principal paydown begins. This can hinder your ability to sell or tap home equity if needed during that time.

ARM Shock

If the interest rate adjusts upward significantly after the interest-only period, monthly payments can skyrocket and become unaffordable when principal paydown begins.

Prepayment Penalties

Trying to refinance or sell the home to avoid a balloon payment may trigger prepayment penalties, making the loan costlier to exit.

When Do Interest-Only Loans Make Sense?

Interest-only loans involve notable risks and should be used cautiously. But in certain situations, their benefits may outweigh their risks.

You Have Concrete Exit Strategy

If you have a clear plan to pay off the balloon payment through predictable cash flow, savings, or proceeds from selling the home, the temporary payment relief can be prudent. Just be sure your exit strategy is realistic.

You Need Short-Term Financing

For a short-term financing need like a bridge loan, paying interest only until you can secure longer-term financing can work. The same applies to tapping a HELOC for a major near-term expense.

You Will Reinvest the Savings

The lower monthly payments free up capital you can invest for higher returns elsewhere or use to pay down higher-interest debts. This allows the interest savings to work for you. Just be disciplined about following through.

You Have Significant Home Equity

If you have sizable equity, the overall loan balance should be low enough to accommodate the balloon payment, or allow you to sell or refinance affordably. Low equity leaves you vulnerable when the payment balloons.

The Interest Rate Is Fixed

Paying only interest is risky if the rate adjusts later, since any rate hikes get multiplied across that same principal balance you didn’t pay down. Locking in a fixed rate contained that risk.

Key Takeaways

Interest-only loans allow temporarily lower payments by avoiding principal paydown. But this perk comes with notable risks like unaffordable balloon payments down the road.

This type of loan demands a concrete payoff plan before the principal comes due. For disciplined borrowers with a clear exit strategy, interest-only loans can provide short-term flexibility. But they require a careful cost-benefit analysis to ensure you don’t end up overextended when it’s time to pay the piper.