Interest-Only Loans

Interest-only loans work by allowing the borrower to pay only the interest due on their loan each month, and making no payments to reduce the loan’s balance. After the specified interest-only period, your payments will increase to a level that allows the loan to fully amortize. This dynamic relays that monthly payments are lower during the initial interest-only period, and, thereafter, rise to a level high enough to make up the difference.

In the distant past, lenders made loans that never amortized. In the 1920s, borrowers paid only the interest owed for the loan’s entire life. Borrowers would simply refinance after the loan’s term ended.

This system worked unless property values fell or the borrower encountered financial hardship such as unemployment. In the Great Depression, many people lost their homes because of these types of loans. This contributed to the current practice of lenders writing loans that will eventually amortize.

Current interest-only loans work the same way, except they allow the interest-only payments for only a short period, such as five years. After this period, the loan’s payments are recalculated to a fully amortizing level. Interest-only loans can be attractive to those that want lower payments in the beginning, but are confident they will be able to deal with the higher payments in the future.

Changing payments on interest-only loans are reminiscent of adjustable rate mortgages (ARMs). However, unlike ARMs, interest-only loans retain a level of certainty. Borrowers can calculate the exact amount by which their payments will rise at the end of the interest-only period. Interest-only loans are also often rationalized by claims that borrowers can invest the monthly savings in payments and get more from their money.

However, in practice, many people will not actually invest. Overall, interest-only loans can be useful, but can also be dangerous because they feature increased payments down the road.