The interest-only payment loan is often used when housing prices are high. By paying only the interest, you get the benefit of a lower monthly payment. This will not only make the payment easier to manage, but it will also allow you to qualify for a higher loan. This allows you to buy a higher-priced property.
The obvious drawback is that you never reduce the amount that you owe. At some point in time you will have to pay off the principal of your loan, and you will still owe all the money that you originally borrowed.
Interest-only loans can be for a shorter term than loans that require payments to include a reduction of the principal. You can get an interest-only loan for as little as five years, sometimes even less. Most other types of first mortgages have a minimum ten-year term, but are typically set at fifteen.
If housing prices are rising, interest-only loans can be very beneficial. You can buy a higher-priced property and still have a payment that you can handle. You can then refinance as the value of your property increases.
Another advantageous situation is if you buy a fixer-upper. If you buy a property in poor condition and renovate it, you will certainly increase its value. This should enable you to refinance when the renovation is completed. You will also have more money to make the repairs, since your interest-only mortgage will have a low monthly payment.
There are risks. If the value of your property does not increase, you will not be able to refinance. You will not be able to sell your property if prices fall below what you owe. Unless you can come up with the money to pay off the loan, you will lose your home.
The second risk is if you would not have qualified for a mortgage unless you got the interest-only loan. If your income and debt situation does not change before the balloon payment is required, you still will not be able to qualify for a standard loan or other principal reduction loan. This risk is not as great as long as property values do not fall, since you will probably be able to get another interest-only loan. However, the risk must be considered. Paying interest only has two equally unpleasant consequences. The first is that you never build equity by paying down the amount you originally borrowed. If you borrow $100,000, for example, and pay interest only for thirty years, you will still owe $100,000.
The second consequence is that you pay more interest. With any loan, your interest is based on your principal balance. With a principal reduction loan, your principal balance becomes less each time you make a payment. This reduces the amount of interest on each subsequent payment. As you near the end of your loan term, almost all your payment is going toward principal reduction and very little is going toward interest.
For most people, the advantage of a principal reduction loan over the interest-only loan is the forced saving feature. With a loan that requires a payment that reduces your principal balance, you are forced to build equity in your home. Because you reduce the principal with each payment, more of each future payment goes to paying the principal. With an interest-only loan, you reduce the principal only if you pay more than the required amount.
There is one clear advantage to the interest-only loan. Since your payment is based on your loan balance, any additional payment above interest will only reduce your monthly payment. With the principal reduction loan your payment stays the same, regardless of your balance. Be sure that your loan allows for principal payments without penalty.
Example: You borrow $100,000 at 6% interest for thirty years. Your monthly payment on a standard fixed rate, fully amortized loan (principal reduction loan) is $599.55 (round to $600). Every payment for thirty years will be $600.
The same terms on an interest-only loan would require a monthly payment of $500 (6% of $100,000 divided by 12). If you paid $100 extra each month, you would reduce your loan at the end of one year by $1,200, to make it $98,800. Your payment (interest only) would now be 6% of $98,800, divided by 12, which is $494.
If you paid an extra $1,200 during the second year, you would reduce your payment even more since you would be paying an extra $106 per month toward principal reduction.
By paying extra on the interest-only loan, you have reduced your monthly payment as well as built equity. Even if you continue to pay the extra $100 per month, you will be paying less than the $600 per month you would have to pay on the principal reduction loan.
Note: These calculations are not exact. Since you are paying the additional $100 monthly, you reduce your required monthly payment. This gives you a slightly lower required payment each month. Using approximate numbers gives you an idea of how it works without a complicated table.
With the interest-only loan, you never reduce the principal by making only the required payments. Your interest amount is always based on the amount that you originally borrowed.