Pitfalls of Interest Only Loans
25 Aug, 2017 / By Jennifer Hamilton
An interest-only loan is a type of loan in which a borrower solely pays the interest on the principal balance for a specific amount of time. That time period is typically 3, 5, or 10 years. The principal payments will then kick in at a higher amount. This loan has many advantages. The monthly interest payments are typically low for the length of the interest-only period. Those particular payments are also tax-deductible. This loan allows a borrower to make a large purchase while retaining the majority of their money for other investments. Essentially, you can buy a more expensive home for a smaller amount of money. There are also disadvantages associated with an interest-only loan.
Lack of Equity
Jack, a pharmaceutical sales rep, and his homemaker wife Jill have been married for several years. They have been saving for a house while living in an apartment. They decide to purchase a home with an interest-only loan. After several negotiations, they settle on $300,000 with the sellers. The couple borrows $240,000 based on Jack’s future income as a District Sales Manager. If they had a traditional mortgage, Jack and Jill would pay their home’s accrued interest along with a small portion of its principal. They would gain equity on the home with each payment made. However, because they are only paying the interest, there is no equity and they are not gaining anything. They are simply servicing a debt.
When Jack’s company implements a hiring freeze, he is no longer eligible for the District Sales Manager position. He and Jill are forced to sell their home and move to a smaller one. They paid the interest-only payments faithfully, but that did not reduce the principal balance of the loan. In the time that they lived there, the home lost value significantly. They still owe the $240,000. They do not get their full $60,000 down payment back. If the house ends up being worth less than $240,000, they will have to pay out of pocket when the house sells. That is definitely a pitfall no one wants to experience.
Spending vs. Investing
An interest-only loan is very attractive, particularly to young married couples. They are starting a new life together and naturally want to purchase a home. Joe, a young groom, discusses the terms of this unique loan with his young bride, Mary. They decide that it is an ideal solution to obtaining their first home. After a few interest-only payments, the young couple is ecstatic about the surplus in their joint checking account. Instead of placing it in an interest-earning savings account or purchasing stocks, they hire a contractor to build a patio deck. When the interest-only term expires, the higher principal payments begin in addition to the interest. Joe and Mary will struggle to pay their “new” mortgage if they do not curb their spending habits.
An interest-only mortgage may have an adjustable interest rate rather than a fixed one. This lessens the risk for the lender but puts the borrower at a major disadvantage. An adjustable-rate mortgage (ARM) can have payments that vary from month-to-month or year-to-year, depending on how it is set up. Predicting payment amounts is impossible; if the rates skyrocket, the payments can become unaffordable for many people.
Some loans also come with what is called a balloon payment. The beginning of this loan looks the same as other interest only loans, requiring you to pay strictly interest. When it changes in 7 to 10 years down the road, a lump sum principal payment will be due. Sometimes this balloon payment is required at the end of the term, but the term is shorter than your standard 30-year mortgage. This leaves you owing a large sum of money in a few short years unless you refinance before that time. Regardless of whether or not you elect to apply for an interest-only loan, please do your homework on all of the advantages and disadvantages.