An interest-only loan is one that gives you the option of paying just the interest or the interest and as much principal as you want in any given month during an initial period of time after your closing.
Most lenders offer a variety of interest-only home loan options, including 30-year fixed-rate mortgages and adjustable-rate mortgages. Typically interest-only home loan programs are offered as interest-only periods of three, five, seven or ten years.
One of the most appealing features of an interest-only loan is that you control your payment amount and your cash flow in any given month during the interest-only period, and your monthly mortgage payment will be lower than it would be with an interest plus principal payment. Your interest rate may or may not be lower than a traditional fully amortizing loan depending on your specific situation, but you will have the option of flexible payments.
There are a number of good reasons to consider an interest only loan. For instance, on a traditional 30-year fixed-rate mortgage, roughly 70% of the payment goes toward interest during the first seven years of the loan. If your interest rate is low, then you've borrowed money at a good rate. Instead of paying down that low rate loan, you could take the extra money you'd have each month from making interest-only payments, and invest it in something that would bring you a higher rate of return.
An interest-only home loan may also be a good option for people who expect to be in their homes for less than ten years. The average homeowner stays in their home between five and seven years. As mentioned before, home mortgage payments go mostly towards interest for the first several years of the loan. Many homeowners like the option of making interest-only payments and using the extra money as they please - save for college tuition, make home improvements, or buy a much-needed new car.
While an interest-only loan may be an appealing option to many, there are a number of common misconceptions that you should be aware of prior to making any final decisions. One common myth is that if you're not paying down your loan's principal, you're not building equity in your home. This is not necessarily true. Homes in the U.S. have been appreciating between 5 and 6% a year. Chances are that even if you're not paying down your principal, you're building equity in your home through appreciation.
Please use the resources available on this website to help you make an informed decision and if you have any questions along the way make sure to use the “Ask An Expert” feature.
