The interest-only loan and its benefits, explained
An interest only loan allows you to pay only the full monthly interest due on your loan for the fixed period of the loan, which can range from 5 to 10 years. During the fixed payment period, you’re required to make only the interest payments; the principal remains unchanged. When the fixed period expires, you begin paying on the principal, too, resulting in an increased mortgage payment.
One unique characteristic of an interest-only loan is that you may elect to make either the minimum monthly payment (the interest-only portion), or, at your discretion, additional payments to be applied to principal to reduce the principal balance. Doing so will reduce your minimum monthly payment in the following month, because the minimum payment will be recalculated based on the remaining loan principal.
This loan could be attractive if your income fluctuates throughout the year based on your salary structure, for instance, based on commissions, bonuses, or stock vesting. By making the interest-only payment, you maximize your cash flow. And in periods when your income spikes, you may elect to reduce your principal. Keep in mind: Some lenders restrict how much you can reduce principal during the early part of the loan.
Characteristics of an interest-only loan
- Payments are lower than those in a traditional mortgage for the initial loan period, usually 5, 7 or 10 years
- Provides flexibility by allowing you to either make the minimum interest-only payment only, or to make the minimum payment plus an additional payment towards principal
- The minimum monthly payment is calculated each month based on the principal; if you make an additional principal payment in one month, the next month’s minimum payment will be lower
- You may qualify for a larger loan amount for a more expensive home
- Although some lenders do restrict how much principal you can pay down during the interest-only period of the loan, most lenders enable you to pay down the principal balance without penalty
Is an interest-only loan the right mortgage option for you?
An interest-only loan may be right if:
- Your income ebbs and flows based on your salary structure and you need to maximize your cash flow between commissions, bonus payments, or stock vesting payouts
- You expect your income to increase before the principal payments come due, thus allowing you to afford the lower payments on a more expensive home now
- You’d rather make the full interest-only payment and put the funds for principal under a fixed-rate loan, or into home improvements or other investment vehicles