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An interest-only loan is a type of financing where the borrower pays interest only for a set period such as 5 to 10 years. During this introductory period, the loan's principal balance remains unchanged. After the interest-only payment period ends, the loan moves to a fully amortizing loan and has payments which include principal and interest. The payments this period tend to be higher since it includes principal and interest. Interest-only loans are used for mortgages, investment properties, and business financing to provide short term relief due to the lower initial payments.
The benefit of an interest-only loan is the lower monthly payment during that period. This payment can keep the borrower's cash flow flexible to allow for short, medium, or long-term reinvestments or expenses. There can be drawbacks to taking a loan like this. By paying nothing toward principal, the borrower builds no equity in the property. When the interest-only period ends, the increase in payments can strain unprepared borrowers. There is also the risk the asset's value declined resulting in negative equity.
Calculating a payment for an interest-only loan is fairly straightforward. To calculate a monthly interest-only payment, multiply the loan amount by the annual interest rate and divide that result by twelve. For example, the annual payment for a loan amount of $300,000, with an annual interest rate of 5 percent (0.05) would be calculated as $300,000 x 0.05 = $15,000. The monthly interest-only payment would be $15,000 / 12 = $1,250.
Borrowers with atypical financial strategies and/or timelines can benefit from an interest-only loans. Time-sensitive real estate investors often prefer interest-only loans. The reduced payment helps them finance their investment while the property appreciates or generates rental cash flow. Individuals expecting to own a property for a limited time such as people who may be selling or relocating within a few years may have little purpose for building equity in the time period so an interest-only loan may be ideal. Individuals with more earnings potential in their future may opt for an interest-only loan. Business owners may opt for this type of loan to keep cash available and reinvest it into their operations in the early years of the loan.
Interest-only loans are used when a borrower is seeking short-term cash flow or believes they will refinance or sell their house prior to the interest-only period ending. For example, it is common in the real estate flipping business where the investor purchases a property, renovates the house, and sells it shortly afterward within the interest-only period. For bridge financing scenarios where a homeowner sells their home but it hasn't closed yet, they may select an interest-only loan to purchase another property. Buyers seeking high or luxury real estate may also utilize interest-only loans to keep their monthly loan payments low, especially if they expect to receive a commission or a sale on another investment. Buyers of commercial properties and/or developers might be interested in keeping their payments low, because cash preservation is key in the start-up growth of a business and/or property.
When the interest-only period ends, the loan now takes on a fully amortized structure. The borrower pays interest and principal over the remaining term of the loan. Some borrowers refinance into another loan with new terms, while others may choose to sell the property if the new payments are beyond the borrower's reach. It is critical that borrowers are prepared for the shift from interest-only payments to fully amortizing monthly payments before the interest-only payment period expires!
An interest-only loan is a type of financing where the borrower pays only interest for a set period of time.
To calculate a monthly interest-only payment, multiply the loan amount by the annual interest rate and divide that result by twelve. For example, the annual payment for a loan amount of $300,000, with an annual interest rate of 5 percent (0.05) would be calculated as $300,000 x 0.05 = $15,000. The monthly interest-only payment would be $15,000 / 12 = $1,250.
The benefit of an interest-only loan is the lower monthly payment during the interest-only period. This payment can keep the borrower's cash flow flexible to allow for short, medium, or long-term reinvestments as well as expenses. This can be particularly beneficial for real estate investors, business owners, or those expecting higher income in the future.
By paying nothing toward the principal amount of the loan during the interest-only period, the borrower builds no equity in the property. When the interest-only period ends, the increase in payments can strain unprepared borrowers. There is also the risk that the asset's value may have decreased resulting in negative equity. Lastly, the total interest paid over the life of the loan is typically higher than with a traditional mortgage.
Interest-only loans can benefit real estate investors who need lower payments while properties appreciate or generate rental income. They can also be suitable for individuals expecting to own a property for a limited time, people who anticipate higher income in the future, or business owners who need to keep cash available to reinvest in their operations during the early years of the loan.
When the interest-only period ends, the loan typically converts to a fully amortizing structure where the borrower pays both principal and interest over the remaining term of the loan.
Interest-only loans are most commonly available for residential, investment, and commercial real estate properties. They may be more difficult to obtain for primary residences.
Payment frequency (e.g. weekly, bi-weekly, or monthly) affects how interest accrues and how payments are calculated. More frequent payments can slightly reduce the total interest paid over the life of the loan. For example, bi-weekly payments result in 26 half-payments per year (equivalent to 13 monthly payments) instead of 12 monthly payments, which can lead to faster principal reduction once the interest-only period ends.