What Is An Interest-Only Loan And How Does It Work?

With most loans, you need to make monthly payments to cover both the loan balance and interest costs. However, an interest only loan works differently given you only need to pay the interest and not the balance of the loan amount for the initial period.

During this temporary period, which generally lasts for 3-10 years, you make payments to clear the interest costs. Once the initial period ends, you are required to make payments to clear the loan principal amount.

Borrowers who have sufficient income and good credit scores can get debt financing with the added advantage of low initial monthly payments. However, these loans are not meant for every borrower as there are potential risks associated with such loans.

The Advantages

Low initial monthly payments are one of the biggest attractions of this loan type. Here are some other advantages:

Flexibility With Cash Flow

Once you make the minimum monthly payment, you have the flexibility to use the surplus funds any way you want to. Depending on your financial situation, you can use the amount to invest in other assets and make profits or put the difference towards your mortgage or loan itself.

Increased Affordability

Given the required monthly payments are lower, you may be able to secure a higher loan amount. The lenders will, of course, consider your debt-to-income ratio, but an interest-only loan gives you the chance to afford a relatively expensive property if your loan type is a mortgage.

Manageable Costs

Since the payments are lower, it may be easier for you to manage repayment with irregular income or cash flow issues without affecting your ability to meet your monthly obligations.

The Disadvantages

Despite the advantage of lower monthly payments, there are some drawbacks that accompany this type of loan that should be carefully considered.

Negative Equity

If your loan is a mortgage, and the value of your home decreases after you have purchased it, you will owe more in the long term than the amount the property will fetch if you sell it.

Loan Conversion

It can be very risky for borrowers who are not sure if their loan will convert. The amount of payments also increases when teaser rates expire, which can be overwhelming for some. Additionally, there is no chance of building any equity in the home. 

Negative Amortization

In some cases, these loans can generate additional interest during the interest-only period. You will have to pay the extra amount when you start clearing the loan principal.

Who Is This Good For?

Interest-only borrowing can be a great option for you if you fall into one of these three categories.

• If You Are Expecting An Increase In Income - It may work for you if you are sure you can make higher payments once you are done with the introductory period. If your loan type is a mortgage, you may be planning to sell the property for a profit before you have to start paying back the principal amount.
• If You Have Irregular But High Income - There are many people who earn good money but not through regular monthly salaries. Many self-employed people enjoy a windfall once a year after their tax rebates. If this is the case, it may be preferable to only pay interest payments each month at first.
• If You Have A High Net Worth But You’re Looking For Added Liquidity - If you are fortunate enough to have wealth tied up in assets, you may still want to access cash that is cheaper to borrow than it is to liquidate an asset.

What To Look Out For

When you are deciding to opt for an interest-only mortgage, these are the additional things you must keep in mind.

• Higher Interest Rates -  These loans are considered riskier compared to conventional loans. To protect their own interests, lenders often charge higher interest-only loan rates.
• Variable Interest Rates - Interest rates are often adjusted in line with a benchmark fund rate. This means that your interest rates will automatically increase alongside the rates of the benchmark fund. To overcome this problematic fluctuation, you should consider locking your interest rates.

Conclusion - Is It Worth It?

Interest only loans give borrowers the flexibility of paying for only the interest amount for the first few years. There are other advantages, like enabling you to afford more despite a lower repayment capacity while helping manage costs without a steady income. 
However, there are disadvantages like negative amortization and negative equity. When you consider borrowing interest-only, keep in mind all options that fit your financial picture.