An interest-only loan is a loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period.
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What is an interest only loan?
An interest only loan is a type of mortgage where the borrower pays only the interest on the loan for a set period of time – usually 5 to 10 years – and then must begin paying both principal and interest. With this type of loan, your monthly payment would stay the same for the first several years, but then would increase once you began paying down the principal.
Interest only loans can be a good option if you are expecting a significant increase in income in the near future or if you need lower payments in order to qualify for a loan. You should be aware, however, that with this type of loan you will end up paying more interest over the life of the loan because you are not building equity in your home during the interest-only period.
How do interest only loans work?
With an interest only loan, you only pay the interest on the loan for a specific period of time. During that time, you don’t pay down any of the principal (the amount you borrowed). After the interest-only period ends, you’ll begin paying both interest and principal every month until the loan is repaid.
Interest only loans are often used when people are buying a home they expect to sell within a few years. They can also be used by people who want to keep their monthly payments low during the early years of homeownership, when they may have other financial obligations such as starting a family or sending children to college.
Interest only loans can be fixed-rate or adjustable-rate mortgages (ARMs). They usually have terms of three to 10 years. At the end of the interest-only period, the loan payments reset and are higher than they were before because they include both principal and interest. That’s why these loans are sometimes called “reset” mortgages.
Advantages of an interest only loan
There are several advantages of taking out an interest only loan. One advantage is that you will have lower monthly payments since you are only paying the interest on the loan. This can help you free up cash each month for other purposes.
Another advantage of an interest only loan is that it can help you qualify for a larger loan amount. This is because the monthly payments are lower, so lenders may be willing to lend you more money.
Lastly, an interest only loan can provide flexibility in how you make your payments. For example, some loans allow you to make interest-only payments for a certain number of years before switching to a traditional repayment plan. This can give you time to save up money or invest it in other ways.
Disadvantages of an interest only loan
An interest only loan can be a great option for borrowers who want lower monthly payments. However, there are some disadvantages to this type of loan that borrowers should be aware of before they decide to apply for one.
First, the monthly payments on an interest only loan are not going to go toward the principal of the loan. This means that the borrower will still owe the same amount of money at the end of the loan term as they did when they first took out the loan.
Second, since the borrower is not paying down the principal of the loan, their equity in the property will not grow. This can be a problem if the borrower needs to sell the property or refinance at some point in the future.
Third, interest only loans typically have higher interest rates than other types of loans. This means that the borrower will end up paying more money in interest over the life of the loan.
Fourth, if something happens and the borrower is unable to make their monthly interest payment, they could face foreclosure on their home. This is a serious risk that all borrowers should be aware of before they decide to take out an interest only loan.
How to qualify for an interest only loan
In order to qualify for an interest only loan, you will need to have a good credit score and a steady income. Lenders will also want to see that you have a low debt-to-income ratio. You will also need to have a down payment of at least 20% of the purchase price of the home.