You've probably seen ads for interest-only loans if you're looking for a house or trying to refinance. Some homebuyers might be glad they took out an interest-only loan, but other homebuyers might be sorry they did.
IO loans are set up so that the borrower only has to pay the interest each month. The borrower does not have to pay on the principal balance, but he or she can do so if he or she wants to.
Most of the time, this option to pay interest is only available for a short time, usually between 5 and 10 years.
This kind of loan can be helpful for people whose incomes change often or who expect their incomes to go up in the near future. Some borrowers feel more comfortable with IO loans than with other types of loans that require payments on the principal every month. This is because the borrower can choose when to pay on the principal.
But if the borrower doesn't pay anything toward the principal, the whole amount will be due at the end of the term. When the term of an IO loan is over, any unpaid principal must be paid or the loan must be refinanced.
People who want to buy a "starter home" often choose IO loans because they expect to make more money soon and want to move up to a second home.
IO loans can be helpful for homebuyers who want to have as many options as possible because they require a smaller down payment. This means that the borrower can usually qualify for a bigger loan.
Borrowers who have other high-return investments can also benefit from interest-only loans, because the extra cash they get each month lets them invest in stocks or start their own business. This is a good choice if the other investments earn more interest than the interest rate on the IO loan.
Buyers in markets where homes are going up in value quickly might also benefit from interest-only loans. If you plan to "flip" your house, or sell it quickly for a profit, an IO loan might be the best option.
There are risks for the person who takes out an interest-only loan. What if you don't get the higher income you were hoping for? What should you do if you want to sell your house but can't find a buyer or an offer that will make you money? And not all borrowers can bring themselves to pay down the principal when they are not required to.
With predatory lending on the rise, be wary of lenders who offer interest-only loans with a lower interest rate than other types of loans. Most of the time, the interest rate on IO loans is higher than the rate on loans that don't have an interest-only option. Be wary of low rates on loans that only pay the interest.
The borrower doesn't have to pay for mortgage insurance. This is another common lie. This never happens. Because IO loans are riskier for the lender than other loans, the lender will want mortgage insurance on the loan.
Every situation is different, and the best way to compare loans and make a good financial choice is to know what your options are. There are many different kinds of mortgage loans, and one of them is sure to be the best one for you. To choose the right loan, you must first understand how they work.
