Interest-Only Loans

New homebuyers who need to keep mortgage payments as low as possible often consider borrowing interest-only mortgage loans when they purchase their home.  An interest-only loan provides the borrower with the requisite funds in exchange for a low monthly payment for the duration of the loan period.  At the end of the loan (generally this is five, ten, or even 15 years), the borrower must satisfy the principal, because the payments that were made applied only to the accrued interest. There are significant advantages to borrowing interest-only loans, but these advantages must be weighed carefully against the disadvantages before deciding whether this type of loan is right for your financial situation.

Lending experts advise typical homebuyers who intend to borrow a moderate amount in a mortgage loan to steer clear of this type of loan program.  However, savvy investors who are confident in their ability to generate income may be very wise to consider an interest-only loan.

Here is an Overview of How an Interest-Only Loan Works:

1. The borrower purchases a home with loan proceeds from a mortgage lender.
2. The borrower is required to pay only the interest that accrues on the loan principle, in the form of monthly payments over a period of around five to seven years.
3. At the conclusion of the five-to-seven-year loan term, the borrower has several options for paying off the remaining balance of the mortgage:
   1. Making a lump-sum payment
   2. Refinancing
   3. Agreeing to a new payment schedule whereby the borrower begins to pay off the principal of the mortgage loan.

Here is a Brief Explanation of the Three Pay-Off Options Presented Above:

• Making a lump-sum payment: Generally, any type of funds can be used to pay off the remaining principal on an interest-free loan.  This might include an inheritance, proceeds from successful investing or even another mortgage loan.
• Refinancing:  Refinancing means that the home owner has opted to roll the remaining principal into another mortgage.  This usually is not an interest-only loan.  A homeowner can choose among many refinancing options.  The option to refinance, or extend, an interest-only loan at the end of the loan period is included in the contract. The borrower is not limited to using hi sor her lender for refinancing, however, and should shop around for the best refinancing rates.
• Agreeing to a new payment schedule: Moving to a different payment plan in order to begin paying off the remaining balance is generally the most costly option for the borrower. However, those who have experienced a large increase in their income may find the option to be financially viable.

As you can see, this type of loan is excellent for someone who wants to buy an expensive home that is beyond his or her current resources, but who expects to have a significantly higher income by the end of the initial loan period.  Also, homebuyers who are investors may find that an interest-only loan allows them to avoid making large payment up-front, thereby investing their extra money so that at the end of the loan period they will be prepared to pay off the remaining balance.

Another group of buyers who are well served by an interest-only mortgage are those who earn most of their income through commission-based sales and corporate bonus programs.  This might include sales people or high-salaried executives who earn bi-annual bonuses that represent a significant portion of their income.

Lenders are pushing interest-only loans now, because there are many expensive homes on the market and not enough buyers who can qualify for the extremely high mortgage amounts.  Those who do not quality for traditional fixed or adjustable rate mortgage programs are often able to qualify for an interest-only loan. Lender finds such programs to be advantageous for the needs of the borrower, as well as their own needs.

Sometimes interest-only mortgage loans are a great option for entrepreneurs who need to maximize their cash flow when starting a business. By avoiding a traditional mortgage, the entrepreneur retains more cash on hand to deal with unforeseen business expenses.

However, most financial advisors do not recommend that their clients borrow interest-only loans.  They warn potential homebuyers against this type of mortgage program by raising questions about whether the home might decrease in value.  In this case, the buyer might be unable to sell in a few years.  Even if the home decreases in value, the borrower must pay off the amount that was borrowed initially. Decreased value can lead to problems with refinancing as well.

Homebuyers who are fairly certain that the value of their new home will maintain its current value, or increase in value, stand a better chance of getting their money’s worth when buying a new home with an interest-free loan program.

Sometimes borrowers who intend to invest the savings that result from the low monthly payments will successfully invest hundreds of dollars remaining each month. Unfortunately, there is a tendency among borrowers to spend rather than invest.  In these cases, the results can be disastrous. 

Borrowing an interest-only mortgage seems like a great savings tool for young borrowers. However, these borrowers are strongly advised to work with a financial advisor when opting to borrow this type of loan.

Pressure from realtors and buyers alike have brought interest-only loans back to the ranks of traditional mortgages, as interest rates and home prices have steadily increased.  Lenders have discovered that they can broaden their customer base by offering a wider variety of loan programs to meet other types of needs.  Most national lenders now offer at least a few types of interest-only loan programs.

Lenders look at several factors when evaluating potential borrowers for these loan programs.  Most often, the lender evaluates the potential borrower based on his or her ability to repay a traditional 30-year fixed-rate loan for the same amount requested as that which is being requested under an interest-only loan. Offering an interest-only loan to a borrower who could repay a traditional loan presents much less risk to lenders.

This is not to say that lenders will not offer interest-only loans to less qualified borrowers.  Future earning potential, bonus structures and future investment earnings can be considered when a borrower is evaluated for an interest-only loan.  Lenders are often unable to consider these factors when determining approval for a traditional loan.

Remember that the lender is in the mortgage business to earn a profit.  Lenders are sometimes willing to take a risk on potential borrowers in order to get their business.  You are the only one who can make the determination of whether an interest-only mortgage loan is a good decision for you.

If you are considering an interest-only mortgage for the purchase of your next home, discuss the idea with your realtor.  He or she has years of experience that show which programs tend to work for buyers, and which specific lenders offer the most favorable terms.  After discussing possible mortgage options with your realtor, you will probably have a better idea of whether this type of program will work to your advantage.