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What is an Interest Only home loan?

An interest only loan is a loan that offers an initial interest-only period, which can range from three to ten years, during which you are only required to pay the interest on the loan. At the end of that initial period, the payment is raised to the fully amortizing level. The obvious advantage to this type of mortgage is that it can significantly reduce your monthly mortgage payment.

Consider a $300,000 loan at 5.5% amortized over 30 years. This loan would result in a monthly payment of principal and interest of about $1700. The same loan with an interest-only option would require a payment of only about $1375.

It is important to note that in this example, we are comparing loans with the same interest rate. Often, a lender may claim that an interest-only loan has a lower interest rate, but the comparison being made may not always be valid. For example, an adjustable rate mortgage with an interest-only option will have a lower rate than a fixed rate mortgage without the option, but that is because the rates on adjustable rate mortgages are lower. In fact, an interest-only ARM will usually have a slightly higher rate than a comparable fully amortized ARM, since the risk of default tends to be higher on interest-only loans.

Beware of the end of the interest-only period

Before getting into an interest-only loan, it is important to realize that once the interest-only period ends, your monthly payment will dramatically increase. Suddenly you will have to pay principal on the loan, often at a higher interest rate than during the initial period. As a consequence, you should not consider an interest only loan if it is the only way you can afford a home. If all of your income is going towards paying an interest-only loan, you are not assured of building equity and you are not saving the money that you will need to make the mortgage payments once the interest-only period ends.

Who is best suited for an interest-only loan?

On the other hand, interest only loans can be excellent choices for the disciplined investor. If you have a low interest rate on your loan, you can take the take the extra savings from not having to pay the principal and apply it to higher interest debt like your credit cards. Alternatively, you can invest it in something else that will yield a higher return.

Interest only loans can also be suitable for people who have unstable or sporadic income, such as those who are self-employed or receive seasonal bonuses. Because they allow you to control your payment amount and your cash flow in any given month, you can have the flexibility of paying either the minimum amount or including principal in your payment if the money is available.

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