Interest-only loans allow borrowers to pay only the interest portion of the loan for a specific period, resulting in lower monthly payments. However, this increases the total amount repaid and does not build equity. It is suitable for those planning to sell or refinance their home within a short period.
An interest-only repayment schedule details the monthly payment on a loan with an interest-only option. In such a loan, there is a specific period of time in which the borrower can only pay the interest portion of the loan, resulting in lower monthly payments for a specified duration. With a fully amortized loan, all payments made to the lender include an allowance for the principal, or amount borrowed, and an allowance for the interest portion of the loan.
Most interest only loans are structured in two different and distinct periods. There is an interest-only period during which the borrower is only responsible for paying the interest on the loan. The length of the interest-only period will vary depending on the specific terms and conditions of the loan. Once this is complete, the loan will be restructured and will require fully amortized payments for the remainder of the loan term.
The advantage of an interest-only loan is that it offers lower monthly payments over the initial term of the loan. Borrowers who choose this type of loan often do so when they plan to sell or refinance their home within a short period of time after purchase. When home prices are in a period of rapid appreciation, an interest only loan gives the borrower the ability to make low monthly payments until the home is resold at a profit or refinanced.
Here’s how an interest-only repayment schedule works. This example assumes that a borrower wants to buy a house for $100,000 United States Dollars (USD) at an interest rate of 5.5%. If the loan is a 30-year mortgage, with a 15-year interest-only option, the monthly payments for the first 15 years of the loan would be $458.33. After the interest-only period has elapsed, the fully amortized monthly payment for the second half of the 30-year loan term would increase to $817.08 USD.
In contrast to the interest-only repayment schedule, if the same borrower chose a 30-year conventional mortgage, the monthly payment over the life of the loan would be $567.69 USD. The first payment on the conventional loan would consist of $458.33 USD for the interest on the loan and $109.46 USD which is allocated to the principal. However, the second payment on the conventional loan, while totaling $567.69, would consist of $457.83 for interest and $109.96 for principal. The last payment on the loan, again totaling $567.79, would consist of an allowance of $2.59 in interest and $565.20 in principal.
The above example illustrates a possible disadvantage of an interest-only repayment schedule. With an interest-only loan, lower monthly payments up front actually increase the total amount the borrower repays the lender. Using the examples above, someone borrowing $100,000 on a conventional repayment schedule would pay $204,404 over the life of the loan. The borrower who opts for the interest-only repayment program would pay $229,575 USD over the life of the loan.
Another possible disadvantage of an interest-only repayment schedule is that a borrower who chooses to make interest-only payments would not build any equity, other than property appreciation. With no payments applied to principal during the interest-only period, the principal balance does not begin to decrease until the borrower makes payments above the interest-only amount. Consumers interested in a loan with an interest-only option should contact a mortgage lender for more information.
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