Why use an interest-only loan?

An interest only loan is not a new concept but is becoming more popular. What is an interest only loan and why would you want one? The simple answer is to free up more cash or to get more house than you could otherwise afford.

The idea of an interest only loan is exactly what it sounds like. For the first few years of your loan you only repay the interest on the principal. After a period of time, generally five years, you renegotiate the loan and then begin to repay the principal as well. This can be extremely beneficial to you depending upon your current situation.

To see how an interest only loan might work for you lets consider an example of a $500,000 mortgage over 5 years. With an interest only loan at 3.875% you would pay $1,615 a month. With a hybrid mortgage at 3.75% you would pay $2,316 a month. And with a 30 year fixed mortgage at 5.75% you would pay $2,918 a month.

As you can see an interest only loan saves you about $1,000 a month. However it also means that you end up paying more interest over the term of the loan since you are not reducing the interest. For this reason interest only loans do not make sense for most normal mortgage situations but there are times that they do. For example, you may know that your job situation is about to improve and you will be able to afford a larger home in the next few years.

One very common reason for a person to enter into an interest only loan is if you are an aggressive investor in anything ranging from real estate to the stock market. If you are a savvy real estate investor then you may very well know that property values are going to increase in a particular area in a short period of time, at which point you plan on selling the property. Since you are planning on flipping the property in a short period of time it paying down the principal of the loan is not important especially since the money could be leveraged for other projects.

Another time that an interest only loan makes a lot of sense is when you can get a higher rate of return on investments than you would be charged for interest on your mortgage. A mortgage may cost you 5% but you may be getting a 15% return on your investments. In this case you would be better off to get an interest only loan and invest the amount that you would have paid on your mortgage. The return on your investments would very shortly add up to more than you would normally have to pay on your mortgage each month. This would mean that you are getting a “free” home since the principal is being paid down faster by the profits on the investments than normally would happen.

Of course investing doesn’t come without some risk, and very likely more risk than most of us are willing to take. Most investors who are using this type of mortgage have enough investments that they can absorb some losses without impacting their bottom end. This is a luxury that most small investors do not have and thus is the reason most of us should carefully consider our position before entering in to an interest only loan.

An interesting thing to keep in mind is the events of the great depression. Before the big market crash the stock market was booming and there did not seem to be an end to the profits that could be made. It almost didn’t matter which stocks you purchased since everything was going up in price so aggressively. With huge profits being made on the stock market many people began investing in real estate and used interest only loans since they where making so much money on the stock market. Of course the market did crash and this resulted in many people loosing not only all the money they had earned, saved or invested but also all their properties and other assets when banks began to foreclose. While this is an extreme example it is a lesson to keep in mind before investing too heavily.

Interest only loans are a great way to leverage your assets and build your wealth but it does not come without some degree of risk. If you are a skilled investor or you know for a fact that your situation is going to improve in the near future than an interest only loan may be of great value to you. Not only will it allow you to get the home that you can afford tomorrow, but it may also allow you to make more money than the principal portion of the loan would cost you.