Interest Only Loan
Interest Only loans have become prevalent over the past 5-7 years and have become an attractive option for many homeowners. Interest Only options can be tied to an ARM or fixed rate mortgage and have now become commonplace in the market. With an interest only loan, your payment only covers the interest portion of the payment with no contribution towards your principal balance. So, if you always make the required payment, your principal balance never reduces, but as a trade off your payment will be lower than a principal and interest loan. As an example, on a $200,000 loan at 6.000% your principal/interest payment will be $1199 per month, on an interest only it would be $1,000. The higher the loan amount, the greater the difference.
Not For Everyone
In our opinion, this type of loan makes sense for somebody who plans on living in their home for less than 5 years; because the amount of principal paid down in that time is minimal due to the way amortization schedules work on principal/interest loans. You can take that money that you would be applying towards principal and invest it in a low-risk interest bearing account if you have the diligence to do that. This type of financing also makes sense for a borrower who may receive large bonus checks periodically and needs a low monthly payment in between these pay-outs. They can then apply however much they want towards principal at that time.
The other nice point of having an interest only loan is that as you make larger payments towards principal each month, your balance reduces and your payment in turn reduces. On a principal and interest loan this is not the case.
Potential Drawbacks
The only drawbacks to this loan are the following: Typically the interest rate is .125% -.500% higher for interest only due to a higher degree of risk for the lender because you are not paying back your debt. Also, at some point in time you are going to have to pay this principal balance down because your loan will not be interest only forever. Typical interest only periods last for 10yrs on your loan until you are required to begin making principal and interest payments to the lender. Also, lenders are making it increasingly more difficult to qualify for the interest only option such as having more down payment and higher fico scores.