An interest-only loan is a fixed-term loan for which you pay only the interest, leaving the balance of the principal unchanged over the term of the loan. In America an interest-only period is typically between one and five years, sometimes extending as long as ten years. After this time, the borrower has the option to pay the principal, convert to an amortized (principal and interest payment) loan, or take out an interest-only mortgage.
Advantages of an Interest-only Loan
The practical result of taking out an interest-only loan is that your repayments are substantially lower than they would be with a conventional loan. This leaves you with increased cash-flow for the period of the loan, and gives you the option of using the extra money to create investments in other areas. It also means that you can afford a larger mortgage than you could by more traditional means.
Because loan interest is tax-deductible, your entire monthly payment qualifies for deductions during the period of the interest-only loan.
You have the Option to Pay
If you take out an interest-only loan, you're not confined to paying only interest for the length of the loan. You're not required to pay principal under the terms of the loan, but you can make principal payments at any time, which will build equity in your property and reduce your interest payments.
Disadvantages of an Interest-only Loan
No Principal Payment Equals No
One of the most significant risks of an interest-only loan is that when you're not paying off principal, you're usually not building equity. If you're forced to sell up and move much sooner than you expected, you may end up losing a significant amount of money in agent fees and closing costs - and you've got no equity in the house to help offset those unforeseen expenses.
With an Interest-only Loan, You're at the
Mercy of the Market
An interest-only loan can quickly turn into a financial trap if the property market stagnates, or if mortgage interest rates rise sharply (most interest-only loans have an adjustable interest rate). And if the worst happens and the value of your property decreases, you stand a good chance of owing much more than the home is actually worth.
The Interest-only Period Will
And when it does, your mortgage payments will rise sharply. You may think you have it covered, but what if your plans end up falling short? If you take out an interest-only loan because you can't afford a conventional one, and then you don't get that salary-increase you were counting on, you'll find yourself unable to meet the amortized payments that you couldn't afford in the beginning.
Take Out an Interest-only Loan for the Right Reasons
- Think twice before taking out an interest-only loan if it's the only way you can afford a mortgage.
- Consider an interest-only loan if you're planning to use the extra money for higher-yield investments (your investment return must be higher than the interest rate on your loan).
- If you know you're not disciplined enough to make principal payments when you can afford to, an interest-only loan may not be the right choice.
- An interest-only loan is a good option if your income fluctuates but is high enough, on average, to afford an amortized payment (and you know you'll make principal payments when you have money to spare).