Interest-only loans are a type of loan where the borrower is only required to pay the interest on the loan for a specified period of time. After the interest-only period, the borrower is then required to make principal and interest payments for the remainder of the loan term. While interest-only loans can be beneficial for some borrowers, they also come with their own set of pros and cons.
Pros of Interest-only loans
- Lower initial payments: Since the borrower is only required to pay the interest on the loan during the interest-only period, their initial payments will be lower than if they were required to make principal and interest payments from the start of the loan.
- More cash flow: Lower initial payments can provide borrowers with more cash flow, which they can use for other expenses or investments.
- Flexibility: Interest-only loans can provide borrowers with more flexibility in their payments. If they experience a financial hardship, they may be able to only make interest payments for a period of time until they can get back on their feet.
- Higher loan amounts: Since the initial payments are lower, borrowers may be able to qualify for a higher loan amount than they would if they were required to make principal and interest payments from the start of the loan.
Cons of Interest-only loans
- Higher overall cost: While the initial payments may be lower, the overall cost of an interest-only loan will be higher since the borrower is only paying the interest during the interest-only period. This means they will pay more in interest over the life of the loan.
- No equity building: Since the borrower is not paying down the principal during the interest-only period, they are not building equity in the property. This means they will not be able to use the equity for other purposes such as home improvements or refinancing.
- Payment shock: When the interest-only period ends, the borrower will be required to make principal and interest payments, which can result in a significant increase in their monthly payments. This can be difficult for borrowers who did not plan for the increase in payments.
- Risk of negative amortization: If the interest-only payments do not cover the full amount of interest owed, the borrower may experience negative amortization, which means the unpaid interest is added to the principal balance of the loan. This can result in the borrower owing more on the loan than they originally borrowed.
Interest-only loans can be a good option for borrowers who need lower initial payments or more cash flow. However, they come with their own set of risks and drawbacks, including a higher overall cost, no equity building, payment shock, and the risk of negative amortization. Borrowers should carefully consider their financial situation and long-term goals before deciding if an interest-only loan is right for them.