Interest LoansVanta Commercial Lending Interest Only Loans
The monthly payments you make for most loans go towards the interest costs as well as your loan balance. You gradually eliminate debt over time by keeping up with the interest charges. However, interest-only loans can work in a different way that results in lower payments every month. You will eventually have to pay off the loan, which is why you need to be aware of the advantages and drawbacks of postponing the repayment.
What’s an Interest-Only Loan?
It is a loan that allows you to pay just the interest costs albeit temporarily without being required to pay down the balance on your loan. Once the interest-only period lapses, which is usually 5 to 10 years, you have to start paying off the debt by making principal payments.
Monthly payments for the interest-only loans are generally lower than those for the standard amortizing loans (amortization refers to the payment of debt over time). The reason for this is that standard loans usually include the interest cost as well as a portion of the loan balance.
If you want to calculate payments on interest-only loans, simply multiply the balance on the loan by the interest rate. For instance, if you owe $50,000 at 4 percent, your annual interest-only payment would be $2,000 or $166.67 monthly.
The following Google Sheets tools can help:
Have an interest-only loan calculator do the calculations for you.
Compare the interest-only payments to fully amortizing loan payments.
The interest-only payments will not last forever. You can repay the balance on the loan in various ways:
The loan will convert at some point to an amortizing loan where the monthly payments are higher. With each payment, you will pay both principal and interest.
You make a considerable balloon payment when the interest-only period ends.
You pay off the loan by refinancing and acquiring a new loan.
Interest-Only Loans: The Advantages
Interest-only mortgages as well as other loans tend to be appealing due to the low monthly payments. What are some of the popular reasons why people choose smaller payments?
Buying More Expensive Property
Interest-only loans allow you to buy homes that are more expensive than what you would afford with a regular fixed-rate mortgage. Lenders typically calculate how much you can borrow based on your debt-to-income ratio and your monthly income. The interest-only loan has lower repayments, which means that there’s a significant increase in the amount you can borrow. If you are confident that you can afford a property that’s priced higher and are willing to take the risk that sometimes things might fail to go as you plan, an interest-only loan makes this possible.
Freeing Up Your Cash Flow
Lower monthly payments also let you choose how and where to put your money. You can put extra money if you want towards your mortgage every month, which more or less mirrors a standard “fully amortizing” payment. Alternatively, you can choose to invest the money is something different such as a business, but it is all up to you to choose. House-flipping loans are almost always interest-only to maximize the amount of money that goes towards improvements.
Keeping the Costs Low
The interest-only payment is sometimes the only payment that you are able to afford. The property you choose might be inexpensive, but you might still find yourself coming up short on funds each month. Interest-only loans give you an alternative to rent payment, but it is important not to ignore the risks. You need to distinguish between the actual benefits and the temptation of lower monthly payments. Interest-only loans work when used the right way i.e. as part of a strategy. If you are simply using an interest-only loan to afford more purchases, it will be easier for you to get into trouble. For instance, an interest-only loan can make sense if your income is irregular. Perhaps you earn variable commissions or bonuses rather than a steady paycheck every month. It could work to ensure that your monthly obligations stay low and make large lump-sum payments and reduce the principal if you have extra funds. However, you first have to follow through on such a plan. Interest-only loans also allow you to customize our amortization schedule. In most instances, the extra payments against the principal result in lower required payments in subsequent months since the principal amount you pay interest on reduce. Check with the lender, however, since some loans don’t adjust the payments or payments don’t change immediately.
Interest-Only Loans: The Drawbacks
The lower monthly payments definitely come at a cost. So, what will you have to give up when you just pay interest on the loan?
Interest-only mortgages don’t help you build equity in your home. It is possible to build equity in your home by making additional payments, but the loan doesn’t particularly encourage that by design. If you ever need cash for upgrades in the future, you will have a harder time using home equity loans.
Paying down the balance on a loan is helpful for a variety of reasons. One of them is lowering risk when it comes to selling. If the property loses value after purchasing it, you might actually owe more on it that you can sell it for, which is referred to as being underwater or upside-down. In case you find yourself in such a situation, you will have to write a large check just to sell the property.
Postponing the Inevitable
You will eventually have to pay off the loan, and interest-only loans just make it harder. You might assume that you will be in a better financial position in the future, but it is always advisable to buy what you can comfortably afford now.
If you only pay interest, you will be owing exactly the same amount in a decade that you owe now. You will simply be servicing a debt as opposed to improving your balance sheet or paying it off.
Example: Assume that you purchase a property for $200,000 and borrow 80 percent i.e. $160,000. If you make interest-only payments, you will still owe $160,000 on the property until the interest-only period is over. If the property loses its value and is only worth $180,000 when you sell it, you won’t get the full $40,000 from the down payment back. In case the price drops lower than $160,000 when you sell it, you will need to pay out-of-pocket to repay the lender to get the lien on the property removed.
You must pay off the loan one way or another. Usually, you end up having to sell the property or refinancing the mortgage to pay off an interest-only loan. If you want to keep both the loan and the property, you will eventually need to start paying principal with every monthly payment. The conversion might happen after 10 years. The loan agreement explains exactly when the interest-only period ends and what will happen afterwards.
Interest-only loans are not inherently bad. However, people often use them in a wrong way. If you have a solid strategy for other uses for the additional money as well as a plan to get rid of your debt, they can work great. Taking out an interest-only loan just for purchasing a property that’s more expensive is an incredibly risky approach.