An interest-only loan is a type of
loan whereby the borrower has to pay only the interest portion for the first few years. Under an interest-free loan, the balance pertaining to the principal amount does not change over the interest-only loan period. After this period ends, the loan normally gets converted to a traditional mortgage.
Who can benefit from an interest-only loan?
- Person who desires to buy a home on a short notice
- Person who wants a lower initial payment with the ability to pay larger loan instalments in future
- Person who wants to invest the money elsewhere to earn a higher rate of return
Key benefits and drawbacks of interest-only loans have been listed below to help the borrower evaluate whether to opt for such a loan option or not.
Benefits
Initial monthly payments are lower
The monthly payments with respect to an interest-only loan are comparatively lower during the initial years as compared to a traditional loan. This helps borrowers to avail the option of buying a bigger or an expensive property. Such an option is favourable, if the borrower agrees to pay higher payments after the expiry of the introductory loan term. For instance, borrowers might see an increase in their income before such an introductory period expires, or some may consider selling their house before the loan gets converted to a conventional mortgage.To avail the initial lower monthly payments, some borrowers may consider switching over to a new interest-only loan. However, this option can be beneficial for the borrower only if the interest rate is maintained on the lower side.
Easier to pay
A borrower finds it easier to repay an interest-only loan than a traditional loan, though extra payments are directly forwarded towards the principal sum in both the loan options. However, an interest-only loan generates a lower monthly payment due to a lower principal sum as compared to a traditional loan – wherein the principal amounts get reduced over time through the monthly instalment remains the same. Hence, borrowers can repay such loans easily and in a faster way realising the benefit immediately.
Build net-worth by investing extra money
By going in for an interest-only loan, borrowers can not only buy a bigger or a better house but also can benefit from the lower initial monthly payments. They can utilise the excess amount thus saved for investing in sources which would earn them a higher rate of return. This would help the borrowers in building their net-worth over the interest-only loan period.
Greater Flexibility
An interest-only loan provides the buyer greater flexibility as compared to the traditional loan due to the lower initial monthly installments in the former. This ensures that borrowers can continue to manage their current lifestyle even if they get lower income in the future or there is a possibility of loss of job, the burden of the monthly payment is lesser in an interest-only loan for the borrower.
Drawbacks
Higher payments after the introductory period
Interest-only loans entail a higher risk for the borrower if they don’t realise that the loan will convert to a higher payment term after the introductory period. If they have not planned their repayment terms properly, then the interest-only loan could be a great burden for borrowers in the later stages.
Uncertainty in potential income
If a borrower goes for an interest-only loan by considering the potential increase in income, and if such a rise does not happen, then the borrower runs the risk of paying a higher payment with a lower income. Refinance options may also not be suitable for borrowers if the interest rates go up.
Fall in property rates
If the property rates fall before opting for an interest-only loan plan, to sell the house before such loan converts, then they face the burden of paying higher loan instalment. This could lead to default payments on the part of borrowers with some even losing their homes. As such, an interest-only loan carries a certain risk for the borrower.
One should be prudent while opting for an interest-only loan.
