Home Buying: All About Interest Only Loans

In the last 10 years, interest only loans have re-emerged as an option for middle class homeowners.

An interest only loan is an option attached to a traditional loan where the buyer may opt to pay only the interest for a number of years. The interest only term may be as short as five years or as long as fifteen years. This type of loan has become popular in recent years. Borrowers want more control over their cash flow and therefore opt to pay the principal of their loan only when they have an excess in income such as yearly bonuses. They like to control how much of the principal they pay and when.

Interest only loans were popular in the 1930's and nearly every homeowner took advantage of this option. When the interest only term ended, the homeowner would simply refinance the loan. This worked well because house prices always appreciated, so an owner was guaranteed a profit when they sold their home. The depression of the 1930's ended this kind of security and so banks stopped writing interest only loans. In the last 10 years, however interest only loans have re-emerged as an option for middle class homeowners.

Interest only loans are a good choice for:

People with income in the form of large bonuses can handle interest only loans. This will allow them to pay down the principal of their loan when they receive their bonuses and to pay a lower amount when they have less income.

People with a good investment plan who do not intend to pay off the home and want to control where to invest their money that would normally go into equity.

Someone whose income will increase in a few years is a good candidate for an interest only loan. A medical student or new lawyer would fall into this category.

People who invest in rental property would do well to get an interest only loan. The lower payment will give the owner better cash flow. However, in the end he will only be able to cash out on any possible appreciation on the home.

An interest only loan is a dangerous choice when:

You use the option because you cannot afford a home any other way.

When your income does not improve and you find yourself unable to pay the loan when the principal comes due. Even worse, you may find yourself unable to refinance you loan.

Things to consider when getting an interest only loan:

Interest only loans do not work well for inexpensive homes. For a home priced at $200,000, your saving will be roughly $200 a month in the beginning. For a house priced at $400,000, your savings will nearly double. It does not make sense to trade $200.00 a month for the risk of not having any equity in your home.

You have the option of making more than the minimum payment and applying it toward principal. This will work well for people who can pay the mortgage most of the time, but from time to time may need to pay less. You must however remain disciplined and continue to may more than the interest when you are able.

If you get an interest only loan for 10 years but move in 5 years, you have essentially rented your home while enjoying benefits of home ownership. It is comparable with leasing a car in many ways. You must keep in mind that your home can depreciate. You may find yourself unable to sell the home at a price that will cover the loan, as your principle may very well be the same as it was when you purchased it. Just as you can pay penalties at the end of a car lease, you can end up paying several thousand dollars to sell your house when you decide to move.

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