Interest-Only Loans: Advantages And Disadvantages

The ideal loans for borrowers who want smaller monthly payments and have steady income are interest-only loans. They may also be advantageous to borrowers who anticipate having more money at the end of their interest-only period than they are already making on their mortgage. But before you apply for this kind of mortgage, be sure to thoroughly assess your circumstances and create a long-term strategy. If not, you run the danger of being shocked by your bill when your rate changes and you have to start paying interest in addition to the principal.

Advantages

Compared to traditional mortgages, interest-only loans give borrowers the option to buy a property with smaller down payments. Additionally, the loans have a flexible payback plan that enables borrowers to pay back principal when their income increases and just pay interest during periods of low income. For borrowers with fluctuating income, such as those in commission-based jobs or those who anticipate having more money by the end of their amortisation period, this flexibility is perfect. Borrowers must be aware, though, that their monthly payments will probably rise significantly once the initial interest-only period expires. These loans are therefore usually only given to borrowers who can comfortably afford the higher payments that will be required in the future or who have the intention of selling or refinancing the property before those larger payments become due. During the housing bubble, speculative buyers employed this tactic because they thought prices would keep rising quickly and would make it simple for them to accumulate equity in their properties.

Dangers

Interest-only loans might be difficult to comprehend and might not be the best option in an environment where interest rates are rising. They are intended to provide short-term financial aid for prudent borrowers who are aware of all the hazards involved. Your monthly payments will rise significantly when the interest-only phase ends and the loan becomes a principle and interest mortgage. Certain loans, such as interest-only adjustable rate mortgages (ARMs), reset every "1" year or "6" months (as in a 10/6 ARM) or after an initial length of time (such as 5 years or 7 years). Because it is hard to predict interest rates at the time the loan starts to re-amortise, it becomes challenging to determine your lifetime cost. If, after the initial payment period, the value of the house drops, an interest-only loan might also be a bad decision. This may make it difficult for you to sell the house and result in high mortgage payments. Interest-only loans are used by some borrowers to buy investment properties with the expectation that the property will increase in value and enable them to settle the debt in the future.

Extended-Term Scheduling

If you are confident in your investments or have anticipated income improvements, opting for an interest-only loan may be a wise decision. Borrowers who only want to reduce their monthly payments, however, want to think about other choices, such as a traditional fixed mortgage. Lower initial payments are another benefit of interest-only loans over other loan types. This can make them appealing to borrowers who hope to buy a more expensive property or who believe that their income will rise in the future. Examples of these borrowers include residents in the medical field or those who are expected to go to executive positions. Your monthly payments will rise dramatically as you start paying principal and interest after the introductory period finishes. This is one of the main disadvantages of interest-only loans, so before adopting one of these, be sure you have a long-term plan for how you will handle future increases in mortgage payments. Interest-only loans are usually only available to borrowers with substantial savings and a low debt-to-income ratio; they also demand a high credit score.

In conclusion

High-achievers who can manage the special requirements of the loan and who fully comprehend the risks should opt for interest-only loans. Because they are speculative in nature, they are typically more expensive than fixed-rate or adjustable-rate mortgages and are not as readily available. An interest-only loan's primary benefit is its significantly smaller first monthly payment schedule. But it's crucial to keep in mind that borrowers will have to start making principal and interest payments or refinancing the loan when the initial interest-only period ends. Additionally, borrowers risk losing value in the event that property values drop because they are not increasing the equity in their properties through principal repayment, which might negate any gains earned during the interest-only period. In addition, property taxes, homeowners insurance, and private mortgage insurance are probably included with an interest-only mortgage in the style of an ARM. These extra expenses might mount up rapidly. Because of this, after the initial interest-free period expires, some borrowers may find it impossible to continue making interest-only loans.