Interest-only loans allow borrowers to defer paying back their full loan amount and only pay for the cost of borrowing money, i.e. interest. This allows borrowers with good credit and sufficient income to get debt financing with low initial repayments. Borrowers can also make payments larger than the minimum interest amount to reduce the loan principal. These loans can be risky for some borrowers, as payments spike after a certain period. As such, interest-only loans are usually reserved for the most qualified borrowers.
- What are Interest-Only Loans?
- What are the Advantages and Disadvantages?
Interest-Only Loans Explained
Interest-only loans are a way for borrowers to reduce the immediate costs of borrowing money. Normally, borrowers must make repayments that include both principal and interest payments. Through the process of amortization, the loan's balance decreases over time. In contrast, interest-only loans can work in two ways. One variety allow borrowers to push back the amortization schedule for a period of time and only pay interest during that time. The other type has a period with interest-only payments followed by one lump sum balloon payment to pay down the principal. These types of loans can be beneficial for very specific kinds of borrowers, including:
- Borrowers who expect an increase in income, like college graduates
- Borrowers with irregular but high incomes, like entertainers and small business owners
- Borrowers with a high-net worth looking to take on debt but maximize their liquidity
While interest-only loans push back full repayment and keep payments low for a time, they're not actually more affordable than normal loans. As seen in the table below, which compares a traditional loan to one with a 10 year interest-only period, interest-only loans can actually end up costing a borrower thousands more over the life of the loan. As such, these types of loan should only be taken out only by borrowers with a solid income looking for short term capital—not by borrowers looking to secure long term affordability.
|30 Year Loan||Traditional||Interest-Only|
|Interest-Only Monthly Payment||—||$1,250|
|Fully Amortized Monthly Payment||$1,610||$1,980˟|
|Total Interest Costs||$279,767||$325,168|
|Total Cost of Loan||$579,767||$625,168|
˟Calculated on the full outstanding balance, $300,000, across the remainder of the loan term, which would be a 20 year amortization schedule.
Interest-only mortgages are commonly used by high net worth homebuyers who want to maximize their use of capital. By making lower initial payments, borrowers can either afford a much more expensive temporary home, or they can put their money towards more lucrative investments. These mortgages usually have a 5 to 10 year interest-only period, followed by a 20 or 30 year period with fully amortized payments.
Interest-only mortgages are a good choice for the borrower who doesn't care about building equity in their home, and who also plans to sell their home before the normal payment schedule begins. To avoid making full payments, borrowers with interest-only mortgages typically terminate their contract early by refinancing into a regular mortgage or selling their home. This way, the mortgage can be paid off with a lump sum balloon payment and excess interest costs can be avoided.
Home Equity Lines of Credit
Home equity lines of credit, also known as HELOCs, allow homeowners to access the equity that they've built up in their homes. After paying down a certain portion of a mortgage—or after reaching a certain loan-to-value ratio, usually 80%—homeowners can draw on the funds they've put down through a HELOC.
For borrowers looking to renovate their home, finance their child's education or pay for unexpected short-term expenses, HELOCs are a relatively affordable way for borrowers to access capital. Typically, lenders will give homeowners "draw periods" of a few years, during which they can access their funds—during this period, only interest is due on the credit that has been accessed. After these periods, the debt is repaid on a normal payment schedule.
For consumers, bridge loans are commonly used to "bridge" the period between buying a new house and selling the old one. For borrowers who want short-term financing to buy a house before their current house is sold, these loans can help pay for the new home's down payment. Lenders typically allow borrowers to defer bridge loan repayment for a few months—during which interest accrues on the loan, but no payments are due. Borrowers usually pay off their bridge loan with the proceeds from selling their house.
Interest-only bridge loans are also available for businesses that need short-term financing. Commercial bridge loans work similarly to consumer loans; businesses who need capital to move offices can get bridge financing before they sell their old office space. Businesses can also use bridge loans to cover gaps in working capital, payroll or inventory. In general, these short-term loans have term lengths under a year and have higher interest rates and fees than traditional loans. Repayment can either be done through fixed monthly payments ("amortized"), or through a balloon or lump sum payment ("unamortized").
- Unamortized Repayment:
- One-time repayment at the end of the term or when your old home sells (if earlier than the term), with interest accruing during this time
- Interest-only payments each month with a balloon payment at the end of the term or when your old home sells (if earlier than the term)
- Amortized Repayment: Fixed monthly payments
Student loans are the most common and least risky type of interest-only loan. When the student borrower is still in school, no loan repayments are due. On federal unsubsidized loans and private student loans, interest accrues during this period. On federal subsidized loans, interest accrues only once the repayment period begins after the borrower graduates from school.
Though no loan repayments are due when student borrowers are in school, the interest that accrues on student loans "capitalizes." This means that the unpaid interest is added to the loan's balance, and any further interest is calculated with that new balance. For borrowers who are able, one way to avoid excess interest capitalization is to pay down some of the interest costs while still in school.
Pros and Cons of Interest-Only Loans
Interest-only loans can be a good way for you or your business to access short-term capital, but the payment schedule and often high fees pose some risks. In general, these loans are a safe choice for borrowers who have a guarantee of increased future income or business revenue. For borrowers unsure of their future finances, interest-only loans are not a good choice, as the benefit of low initial payments is likely not worth the risk of defaulting on the loan.
- Low initial payments
- Can help borrowers access short-term capital
- Can supplement income for high earning borrowers with erratic income streams
- Costs of loan are typically higher in the long term
- There is a sudden spike in repayment when the interest-only period ends
- Payment schedule poses more risk than traditional loans