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What is an Interest only loan?
An Interest only loan is a type of loan where you pay mortgage payments only on the interest for a specified amount of time instead of making payments on both interest and principal. These are usually considered as a non qualified mortgage. The principal amount of the loan remains unchanged during the term as there is no amortization of the principal during the loan period. Usually, the interest only loan is structured as an adjustable rate mortgage called as Interest only ARM. The principal amount is paid either as a lump sum or as subsequent payment method. The loan can be changed to either conventional or balloon payment at the end of the interest only loan period. The interest only loan period could be anywhere between 5 - 10 years on a 30 year loan.
30 year Fixed mortgage
30 Year fixed mortgage is defined as the mortgage which has the fixed interest rate and the monthly mortgage payments stay same for the entire term of 30 years. The monthly payment is low and the repayment period is longer. This loan is usually the preferred loan by many people.
Adjustable rate mortgage
Adjustable rate mortgage is a type of loan where the initial rate is fixed for a certain time, then varies periodically based on the terms of the loan chosen by the borrower and the benchmark interest rate chosen by the lender. For example, 5/1 ARM has an initial interest set for first 5 years, then the interest changes periodically.
Balloon Payment mortgage
Balloon payment mortgage is a type of mortgage that has lower monthly payments initially on the loan but a lump amount is owed during the end of the loan period. These loans are usually good for borrowers with good credit score and substantial income. At the end of the payment period, the borrower may pay off the lump sum, take out another mortgage to pay off the loan or may sell the home to pay off the mortgage with the proceeds.
Qualifying for Interest only loans
To be eligible for the interest only loans, the lender not only sees the current finances of the borrower but also takes into account the future income potential of the borrower. The lenders are usually concerned about what the income potential will look like when the interest only period ends and the higher mortgage payments start to kick in. The requirements to get qualified for interest only loan vary depending on various factors and the lenders.
FICO score usually above 700.
Down payment of at least 15% needed depending on the lender.
Debt to income ratio of at least 36%.
Sufficient income, annual earnings or assets enough to repay the loan during the term of the loan.
Pros of an Interest only loan
Lower payments in interest only period - Initially, the interest only loan has a low monthly payment until the regular payment period kicks in as only interest of the loan is paid in the initial period. The interest only period may differ depending on the terms of the loan. It might be 5, 7 or 10 years.
Increased Cash flow for other investments - This frees up the cash to be invested or leveraged for other investments.
Qualification standards - The qualification standards are less rigid compared to the conventional loans as these loans are not sold to Fannie Mae or Freddie Mac. But this does not mean that the lenders will be lenient on the credit score and annual income. The criteria to be eligible are based on the amount of loan and willingness and flexibility of the lender to provide loans.
Good market Condition - The equity can be built up over time if the market condition is good as the home price seem to increase over time.
Cons of an Interest only loan
Equity remains unchanged - The equity remains unchanged during the initial period of the loan. Once the initial interest only period ends, there is a substantial increase in the monthly mortgage payment. This has higher monthly payments than the conventional loans.
Increased interest rates - There might also be a chance of increased interest rate after the initial interest only period which further increases the monthly payments whereas in conventional loan, the monthly mortgage payments are fixed for the entire term of the loan.
Increased interest payments - The interest paid over the term of the loan is higher compared to the traditional conventional mortgage. The lenders consider interest only loans to be riskier than the conventional loans. In comparison to conventional loans, they have higher interest rates and are offered by fewer lenders.
Who can benefit from Interest only loan
It can be used as an alternative to the Bridge Loan, where the loan can be used as a temporary financing until the current home is sold.
If the person is not planning to keep the home for long and plans to sell it after a short term.
If the person is able to make payments, but plans to increase cash flow so that he or she can invest in business or leverage to invest in other options.
Whom does the Interest only loan impact?
If the person cannot afford at least 15% of the down payment, then it is advisable for the person to consider other loan options.
If the person can afford the p"in other options.
If a person purchases a home in an area in which the home prices are depreciating, it may be difficult to refinance the loan later on.
A conventional loan is a better choice if the person is calculating the cost of the mortgage over the life of the loan.