How Does An Interest Only Loan Work?

Interest Only loans have become very popular in recent years, as they provide several essential benefits, one of which is lower monthly repayments. In contrast to traditional mortgage, IO loan allows the borrower to pay interest only without having to pay the principal. Please check our infographic to find out more about interest only loans and decide whether this type of loan is the right option for you.

Interest Only Loans Advantages - Canada Wide Financial Infographics

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What is Interest Only Loan?

Just as the name implies, an interest only loan allows the borrower to pay interest only. In contrast however, a traditional mortgage requires one to pay some interest and principal in every monthly payment that they make. By eliminating the need to pay the principal, an interest only loan helps to ensure that monthly payments are as low as possible.

Benefits of interest only loans

There are a variety of reasons as to why one might want to have a lower monthly payment. This includes:

  • Being able to buy a pricier home with a smaller monthly payment
  • To free up money for other uses
  • To keep monthly financial obligations as low as possible
  • To create a personal monthly amortization schedule

If one’s income is variable, they stand to benefit a lot from this arrangement. It's also possible for one to customize their amortization schedules with the use of these types of loans.

What is worth noting about interest only loans is that the borrower pays the interest of the mortgage in terms of monthly payment for a term which is fixed on an interest-only mortgage loan. The term for such a loan spans from 5 to 7 years in most instances. After that term is over, many people refinance their homes, make payments in lump sum or start paying off the principal attached to the loan. However, when one is paying the principal, the payments tend to increase significantly.

Who should consider an interest only loan?

One can consider an interest only mortgage in an instance where:

  • They desire to afford a better home now
  • They know that they will need to resale the home after a short period of time
  • They want the initial payment to be lower and they also have confidence of dealing with large payments in future
  • They are certain that they can get a higher rate of returns if they choose to invest the money somewhere else

What are the advantages of interest only loans?

The main advantages of having an interest only loan are:

  • Monthly payments are significantly low during the loan term
  • The borrower might qualify for a larger loan amount later on and then decide to buy a larger home later on
  • This type of a loan arrangement allows the borrower to place extra money into investments in order to effectively build net worth
  • During this interest only period, the entire amount of the monthly payments then qualifies to be tax-deductible.

What are the disadvantages of an interest only loan?

There are also a number of drawbacks that are associated with these types of loans. They include:

  • The rising mortgage rates tend to increase the risk of the loan’s ARM
  • Many people end up spending extra money rather than investing it
  • Many of the borrowers are not able to afford the principal payment when time comes and a large number of these people are not disciplined enough to pay extra towards the principal.
  • Income might not grow as fast as one had planned
  • The home might not appreciate fast in value as the borrower had anticipated

Are there any risks that are associated with these interest only loans?

  1. It can be a major risk when someone is focusing only on the ability of them making interest only payments. The reason for this is that the borrower will definitely have to make principal and interest payments at the end of the month.
  2. If the borrower has got the payment option ARM and they make minimum payments that don’t include the amount of the interest that is due, the unpaid interest is then tacked onto the principal amount.
  3. As much as a borrower can avoid the payment shock that is normally associated with interest only mortgages, it can be hard to predict the level of interest rates in ten years time. At times, refinancing can prove to be a major huddle.
  4. Mortgages like the interest only mortgage normally have a penalty when a borrower prepays. If a loan is refinanced during the penalty period, the borrower might end up owing large sums of money in terms of additional fees.
  5. Lastly, the home might not be as worth as much as the amount owed on the mortgage. Again, it might appreciate in value too fast.

As much as interest only loans are a preferred option for millions of people, it's good to note that not everyone can make such a loan work for them. It is therefore important that the borrower does research in order to see if this type of a loan is right for them and how they can go about getting it. If the borrower finds that it might not be the right option, there are other avenues that they can use in order to qualify for the financing that they require.

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