What are interest-only loans all about?

Inevitably, I field this question during just about every loan application, backyard BBQ, and even in my dreams. 

 

So what’s the buzz around “Interest-only” loans?  Are they good?  Bad?  Are they going to cause the “real estate bubble” to pop?

 

The answer is……it depends.  Let’s take a closer look at what interest-only loans are. 

 

Under traditional programs a borrower’s monthly payment remains fixed.  A portion of that payment is applied to the interest charge determined by the remaining balance and interest rate.  The rest of the payment is applied to paying back the loan.  Over time, the proportion of each payment that goes towards paying back the principal increases.

With interest-only payment programs a borrower is only required to pay the interest portion of the monthly payment.  This keeps the monthly payment lower  but delays repayment of the loan.

 

To compare, lets evaluate two brothers who take out a $200,000 loan at 6.00% on a 30 year loan.  Brother A decides to take out a traditional principal and interest mortgage.  Brother B takes out an interest-only loan.

 

After 36 months, brother A has made $43,168 in total payments and owes $192,168 on his original mortgage.

 

Brother B, who took out an interest-only mortgage has made $36,000 in payments($7,168 less than brother A)   and still owes $200,000 on his loan ($7,832 more than brother A). 

 

At initial glance one may say that brother A is $664 better off than his brother.

 

However, this may not be the case.  Let’s say that brother B had taken his $199 savings per month and invested it in a liquid asset that earned an annualized return of 7.00% over those three years.  In that case, brother B would have a liquid investment account worth $7,946 after 36 months.

 

At this point brother B would be better off by $114.  Now lets say that brother A and B both lose their job and their ability to pay their mortgage.  Unless brother A had other savings he may have a difficult time paying his mortgage.  Brother b however has a liquid asset account that he could use to pay his mortgage for ay least 6 months. 

 

The bottom line is that there are very real risks associated with interest-only loans.  However, when used properly, interest-only loans offer borrowers a tool which can increase liquidity and security.   

 

 

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