What Are Interest-Only Loans?
When you take out a traditional loan, the monthly payments that you make go toward both your loan balance and interest costs. If you keep up with interest charges, you will gradually pay down the debt you owe.
An interest-only loan is where your payments only go toward the interest on the loan. None of the money you pay goes toward your overall loan balance or principal. It allows people to have lower monthly due amounts over a fixed period.
You do need to pay the entire loan off, either by making a lump sum payment, or you can increase your monthly payments to include money that will go toward the principal.
How Do Interest-Only Loans Work?
Interest-only loans typically cost less monthly than a traditional loan structure. The payments are less because none of what you pay goes toward paying off the principal on the loan. The loan is not amortized, which means that you do not pay down any of the original loan amount.
The monthly payment for an interest-only loan can be calculated by multiplying the loan amount by the interest rate you receive. Then, you divide that sum by 12 months.
Interest-only loans are not meant to last forever. There are several ways that you can repay them according to the structure of your loan. Some options are:
- You can convert to an amortizing loan to begin to pay off the principals
- Making a lump sum or balloon payment at the end of the specified loan period
- Pay it off by refinancing and getting another loan.
Advantages of Interest-Only Loans
- You can purchase more expensive property than you might otherwise be able to.
- Costs tend to be lower
- It frees up your cash flow
Disadvantages of Interest-Only Loans
- Risk of being upside down on your loan.
- They are only meant to be temporary
- Negative amortization.
- No equity.