What Is An Interest-Only Loan?

What is an interest-only loan? Interest-only is an option that can be applied to your standard mortgage. If you're shopping for a mortgage you might have heard the term "interest-only loan." To understand...

If you're shopping for a mortgage you might have heard the term "interest-only loan." To understand what this means and decide whether it is a useful option for you, you should first look at a standard mortgage. Anne Reed of Acceptance Mortgage in Sparta, New Jersey is an expert on mortgage loans.

"The typical mortgage is a fully amortized one. Usually 30 year fixed. This means that the customer will pay principal and interest every month," Reed said. "Although the payment will remain the same for 30 years, the payment is not applied the same for the total 30 years. For instance, in the first year of the loan, very little of the monthly payment will go to principal. Rather, most of it is applied to interest. Gradually, more and more of the payment will be applied to principal and at the end of the term; the loan will be paid in full - assuming all payments are made timely."

Interest-only is an option that can be applied to your standard mortgage.

"Interest-only mortgages can be structured a few different ways. They are available in fixed and adjustable rate scenarios. They can be interest only for a specific amount of years and then a balloon payment, or the entire principal balance, is due," Reed said. "A much more popular version of the interest-only loans involves the remaining years on the loan turning into a fully amortized payment after the interest only period. For instance, if a customer was to take a 30 year conventional mortgage with a 10 year interest only period, then only interest payments would be due for the first 10 years. After the initial 10 year interest only period, the mortgage turns into a fully amortized loan for the remaining 20 year period."

Interest-only is not always iron clad. Just as you might pay down a standard mortgage ahead of time you may also put money towards your principal in an interest-only loan at any time.

"Most banks allow the customer to make principal payments if they choose during the interest only period and then their amortized payment for the 20 year period would be adjusted," Reed said. "Some banks will even adjust the interest only payment if a substantial principal reduction is made."

In order to obtain an interest-only loan you will most likely need an excellent credit history.

"Interest-only loans tend to be a little riskier to the lender since the borrower will not be making any principal payments reducing the principal balance. Because of that, lenders typically prefer the borrower to have a solid, positive payment history and a strong equity position. Most lenders require a minimum of 10% of equity in the home before considering interest-only options," Reed said. "For instance, if your home is worth $100,000, the mortgage amount would have to be no more than $90,000 for lenders to CONSIDER offering an interest-only option."

An interest-only loan payment is usually lower than a standard mortgage payment which allows for more flexibility with your budget for the short term. On the negative side, you won't be building equity in your home during the interest-only period. Be sure to take your long and short term financial needs into consideration when thinking about adding an interest-only loan option.

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