Whether you are an investor wanting to grow your portfolio or a buyer looking to purchase your home, taking out a loan to pay off that investment property or that dream house is usually the way to go.
Now each month after taking out a loan, you pay a portion of that loan. Your monthly payment covers both the interest on the loan and the principal, which is the amount that you borrowed from the lender and that which actually pays for the house.
This form of loan where a certain portion of your payment goes to the principal and the rest goes to interest is what many think of as ‘the regular’ kind of loan. There’s another type of loan that defers payment for the principal and borrowers only pay for the interest for a certain period of time. This is called Interest Only (IO) Loan.
Simply Put
An interest only loan has the same benefits a regular loan covers; however, the former enjoys the perks of a lower monthly repayment. This is because as the name suggests, in this type of loan, a borrower only pays for the interest. Lower monthly repayments mean one would be able to buy a bigger and better property or to buy more properties!
Once the Interest Only Loan’s payment term ends, the borrower can either renew the IO loan, repay it through standard loan, or refinance and get another IO loan.
Wait, what about the principal?
Now just because you’re only paying for the interest for a certain period of time doesn’t mean that you won’t have to pay for the principal. Don’t be misled by the term. Interest only loans eventually convert to regular loans. This is when monthly repayments shoot up because this time, you will have to pay for the interest plus the principal that you borrowed.
Here lies the trouble for opting for this kind of loan. You may be saving a lot of money for having to pay for just the interest of the loan at the onset of payment term but remember, the portion of your monthly repayment that’s supposed to be for the principal in regular loans has to be paid EVENTUALLY. You may be saving money at the start but you will have to repay the loan at some point!
Who IO Loans are for
Originally created for investors who plan to hold on to their investment property for a short period of time or not pay down the principal at all, preferring to refinance to release further equity or sell out for capital gain (an investor’s interest payments are tax deductible). The interest only loan has become an attractive option for homebuyers, too. However due to its tricky nature, anyone who intends to use this type of loan needs to study and reconsider his/her options. Interest only loans may not be the right type of loan for all investors and it also may not be available on all types of properties or in all circumstances.
In a nutshell
There are many advantages to interest only loans; the most obvious of which is initial low monthly repayments. However, it comes with a cost. Those who are planning to venture into this kind of borrowing must be aware of its drawbacks short repayment terms (usually up to 10 years), huge jump in payment when the reverts to principal and interest payments and the risk of losing your property if something goes wrong and you can’t refinance.
That stated, interest only loans can be a viable option given the right situation and for the right person. One must assess his/her financial standing and make proper projections if someone plans to explore the possibility of using this type of loan to purchase a property.
Please talk any loan through with your mortgage broker and/or financial advisor/accountant to ensure you understand if an interest only loan is right for your situation.