Purpose of an Interest-Only Loan

The purpose of an interest only loan is to provide a way for an individual to take out a loan. Many of these borrowers can be good lending risks and with the right opportunity and access to financing can participate in the American dream of ownership. Interest only loans are based on providing financing to an individual at a low cost and as their financial situation changes, they are able to pay more as the loan changes.

Interest Only Loans

An interest only loan starts out with a requirement for the borrower to service only the interest portion of the loan payment. The interest only term is usually 5 to 10 years, depending on the type of loan and its purpose. At the end of the interest only period, the borrower is given the option to pay the principal (as would be the case in a balloon payment loan) or convert the loan into an amortized principal plus interest loan for the remainder of the loan term.

Interest Only Loan Example

A borrower who takes a loan of $10,000 for 10 years at 12 percent will repay $17,200 at the end of the loan period. The monthly payments for this loan, if done as a normal principal plus interest loan, would be around $143. If the same loan were made as a 5/5 interest only loan, the borrower would service only the interest portion on the loan for the first 5 years. At the end of 5, the payments would go up for the remainder of the loan’s term of 10 years.

In this case, the payments in the first 5 years would by around $60 a month and increase in a principal plus interest loan after 5 years to $114 per month. An interest rate loan provides a way for borrowers to lower their initial monthly costs for a fixed period.

Word of Caution

Some borrowers using interest only loans should understand that loan payments will increase at some point. The actual monthly payments of the loan provided in the example above would increase even more dramatically when we factor in the fees and other costs related to the interest only loan once it is adjusted to a principal plus interest loan. A borrower should be able to react to the change in payments in order to meet their obligation otherwise look to a traditional fixed-rate loan option instead of an interest only loan.