With an interest only loan, borrowers pay only the interest on the principal balance for a set term, usually between 5 and 10 years. Loan payments during the interest-only period are significantly lower than those after the principal balance is amortized. Interest only loans provide borrowers with flexibility because borrowers are not forced to make principal payments during the interest-only period. However, if a borrower chooses to make payments toward the loan principal during this time, they are free to do so. Borrowers should be aware that unless additional principal payments are made, the principal amount will remain unchanged during the interest-only period of the loan. Interest only loans are an excellent way for home buyers to maximize their buying power, but these types of loans will not be appropriate in all situations.
When an Interest Only Loan is Appropriate
There are several circumstances in which an interest only loan may be a suitable alternative to a traditional loan. While these are not the only situations in which an interest only loan may be appropriate, these are some of the scenarios in which these types of loans are commonly utilized.
Small Salary, Large Bonuses
In some cases, borrowers may earn a steady salary, but the majority of their income comes in the form of infrequent bonuses or commissions. These people often do not have enough money each month to make large loan payments, but they can afford smaller loan payments. At various times during the year, they may earn a commission or bonus that can be applied to the principal loan amount.
Future Earning Power Increases
Young professionals often opt for interest only loans because they expect their earning power to increase over the next few years. This allows them to make smaller payments at the beginning of the loan with the anticipation of larger payments after a set number of years. As their earning power increases over the course of their career, their ability to make payments toward the principal also increases.
Investment in Savings
An interest only loan can provide significant savings compared to a traditional amortizing mortgage. In order for an interest only loan to truly be an investment in savings, the borrower has to be committed to investing the difference between an interest only loan and a traditional loan. Without dedicated investing, an interest only loan could cost the borrower more in the long run. Borrowers need to be confident that their savings investments can actually earn them money.
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