Interest-Only Loans: Past and Present

Interest only loans have been used in the past as a way for borrowers to borrow money from lenders. These loans have lower monthly payments for a set initial period that increase over time, depending on the terms of the loan. Interest only loan payments are calculated using only the interest of the unpaid loan balance, the principal of the loan is never paid. Once the interest only term expires, the loan becomes a fully amortized loan. Usually the monthly payments of a fully amortized loan are significantly higher than those of an interest only loan.

Past Practices

In the past, interest only loans were an ideal way to meet the demand for housing purchases. Between 2002 and 2005, interest only loans went from being 2 percent of mortgage loans to 30 percent of all loans, according to the Federal Reserve Bank of Atlanta. Many borrowers that were entering the home-buying market were first time buyers who had low, poor or bad credit or lacked the necessary down payment and equity requirement to qualify for a traditional mortgage.

Need for Interest Only Loans

Interest only loans provided a way for banks, builders and borrowers to meet the demands of the housing market by matching supply and demand, getting individuals into houses and maintaining the flow of capital. This scenario was a good economic model until the realization that as the economy began to slow around 2007, many individuals did not have the resources or financial sophistication necessary to avoid foreclosure and other financial calamity.

Collapse of the Mortgage Lending

People began to lose their jobs and interest only terms began to change. Many borrowers acquired interest only adjustable rates and could not afford to pay the higher payments. As a result, many banks collapsed and mortgage lending was at a stand still. Banks did not have the assets to give out more money in loans.

The introduction of the federal loan modification program provided an opportunity for some borrowers to restructure their debt in a way to avoid foreclosure and loan default. This program has a few conditions that still leave many borrowers outside the lending circle, but for many,  federally backed conforming 15 or 30-year mortgage provide relief from rising rates.

The Future of Interest Only Loans

The future of interest only loans depends on regulators and the Federal Reserve and U.S. Treasury Department. Interest only loans, in and of themselves, are good products that give borrowers opportunities that may have not existed. Careful consideration should be given to alterative sources of funding as a way to finance the purchase a home, including first time homebuyer grant programs and organizations like Habitat for Humanity among others before taking out an interest only loan.