How to Use an Interest Only Loan

When discussing the different types of home mortgages available; fixed rate, variable rate, hybrid, balloon; one type that comes up often is interest only mortgage. An interest only mortgage is when the monthly payment due consists only of the interest on the loan, not the principal. If the borrower only pays the amount due, the principal is never paid off. Generally speaking, interest only loans are limited to a smaller number of years than a conventional mortgage. This is to protect not only the borrower, but the mortgage holder as well. The lender never gets any payment against the principal and the borrower may never acquire any equity in the home.

Difficulty: Moderate

Instructions

1. There are several circumstances under which an interest only mortgage makes sense. One would be when the borrower has a fluctuating income. Perhaps they are self-employed, or get paid primarily in bonuses or sales commissions. The interest only mortgage would allow the borrower to have a smaller monthly commitment, but could pay down the principal when they have more money available due to higher income in that month or quarter.

2. Another case would be when someone buys a home or condominium for a rental property. Instead of wanting the property to be a long-term investment, they may want to show a positive cash flow from rentals. They would therefore want a lower monthly payment in the early years of the loan. Later, when the rents go up, they can refinance, or simply begin to pay against the principal without changing the terms of the loan.

3. A third scenario when the interest only loan may be attractive is when the borrower is buy and selling the house quickly for a fast gain. In this case, the purchaser would want to make the initial investment as little as possible to increase the profit when the property sells, as well as minimize the risk until it does.

4. With the recent troubles in the housing and mortgage industries, it has become more important than ever to be aware of the risks involved in this type of loan. From the buyer's perspective, this loan makes sense only under a limited number of circumstances. A buyer should never allow themselves to get talked into an interest only loan. If they can't afford the house, they shouldn't take on the burden of a mortgage. On the other side, the lender needs to take steps to insure the borrower isn't trying to avoid paying the principal or avoiding paying for mortgage insurance.