Have you been considering an interest only loan, which is also referred to as an interest only mortgage? If so, make sure you understand what an interest only loan means because often it can be a bad idea, particularly when you do not understand exactly what it means.
What Are Interest Only Loans
Loan seekers often perceive interest-only loans as a loan where the borrower is only responsible for paying the interest. This is not true, but we have to admit it would be cool if it were.
Interest only loans are actually one of the adjustable rate mortgages where the borrower has to make no payments on the loan principal for a preset and specific time frame. Once the time frame passes, the loan borrower then has to make fully amortized payments, which covers the principal and the interest.
An Example of an Interest Only Loan
You have found the perfect home, but your money is tight and you need an affordable mortgage until your financial circumstances change. The loan provider offers you an interest only loan.
This loan may have a five year fixed rate of interest term and a full term of thirty years. This means for five years you would only pay the interest on the loan. However, as soon as the five years are up you have to pay both the interest and the principal until the loan is paid in full.
When you go with this type of loan, the interest rate will be generated from the current LIBOR rate and the bank adds in a margin for their profit, which is based off how risky the loan is.
Why Some Go With Interest Only Loans
Usually, when someone goes with an interest only loan they want to snatch a home off the market before someone else, but have a minimum amount of money they can afford to pay on their mortgage each month. Other times, they may want to have more money for high risk investing, home improvements, paying down other debts, or starting a new business. Lastly, they think that their income will increase during the interest-only period so they will be able to contribute extra money to go towards the principal. Alternatively, they estimate that they will be in a better financial situation once the interest-only period ends to afford a standard mortgage.
Why Interest Only Loans Are a Bad Idea
If you are considering taking out one of these loans for one of the reasons covered in the section above, you may want to reconsider. There are numerous reasons why interest only loans are a bad idea such as the reasons listed below.
- You don’t decrease the mortgage principal – Because you are only paying the interest on the loan you are not making any progress on the mortgage principal, which also means you are not building up your home equity.
- You could lose the home and money is wasted – If you lose your job, you could find yourself in serious trouble. You already will have a hard time making ends meet for other required bills, but you will end up wondering how you will pay even more on your mortgage when the interest-only period ends and may end up losing the home altogether after investing so much money on the interest.
- You may not be able to refinance – If you find your credit score drops when the interest only period is about to end and you planned to refinance, you may not be able to (or it will be difficult), because of your low credit score.
- You won’t be able to get a home equity loan or home equity line of credit – If you need to finance something important you won’t be able to get a HEL or HELOC because the home value has not increased as you expected and you do not have any equity since you haven’t been paying on the principal.