What is an Interest Only Loan?

What is an interest only loan?

1 Answer

Any time you get a loan, with the exception of 0% loans, there will be a PRINCIPAL that needs to be repaid, and the other piece will be the INTEREST.

Principal is the cost or balance of what you are borrowing. For example, if you get a $100,000 loan, your principal is $100,000. As you may be aware, you will pay much, much more than $100,000 over time if you have a 30 year mortgage loan. Anything in excess of $100,000 is interest (or a finance charge).

A normal loan is amortized meaning that it is on a schedule to be paid down over time. In this case, a portion of each payment will go toward paying your principal balance, and the remainder is interest. On a 30 year fixed loan, this is calculated using a front-loaded amortization, meaning much more of your payment goes toward interest in the beginning and much more goes towards principal near the end of the loan.

An INTEREST-ONLY loan specifies a certain period of the loan wherein you will only pay the interest portion of the payment. This is as simple as applying the following calculation to your loan.

The Balance X The Interest Rate

-------------------------------------- = Interest Only Payment


The catch is that any principal you don't pay down will eventually need to be paid. This can either be in the form of a BALLOON payment, or your loan amortization can recast or adjust when your interest only period expires.

For instance, there are 30 year fixed interest only loans. On these, the rate is indeed fixed for all 30 years. But if you were just paying interest only all 30 years, then you would still owe ALL of the principal balance at the end of the loan. Lenders usually specify a period during which the interest only payment will be in effect, either 10 or 15 years normally. So if you are Interest only for the first 15 years, then you will essentially have a 15 year fixed loan for the next 15 years in order to get the balance paid down. It will greatly increase your payment.

Most people that get loans like this are not concerned about using a loan to reduce their principal. They are either allocating the money they save elsewhere or just hoping that their home will appreciate so they can sell or refinance before their payment goes up.

Interest only definitely has it's place, especially in Home Equity Lines of Credit, and Mortgage Acceleration.