Interest Only Loans
An interest-only loan is a loan in which, for a set term, the borrower pays only the interest on the principal balance with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.
A five- or ten-year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years.
The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because he is not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase his salary substantially over the course of the loan to borrow more than he would have otherwise been able to afford, or investors to generate cashflow when they might not otherwise be able to.
During the interest-only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same period of time that would be interest-only).
Interest-only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan structures.
Because a homeowner does not build any equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time he is either ready to sell the house or refinance. He may find himself unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.
Many homeowners saw the values of their homes increase by as much as four times its price in some markets in a five-year span in the early 2000s. Interest-only loans helped homeowners afford more home and earn more appreciation during this time period. However, interest-only loans have contributed greatly to creating the subsequent housing bubble situation, because many borrowers could not afford the fully indexed rate. Interest-only loans may turn out to be bad financial decisions if housing prices drop, causing those borrowers to carry a mortgage larger than the value of the house, which in turn will make it impossible to refinance the house into a fixed-rate mortgage.