Interest Only Loans

by Tanya Davis

Normally, mortgage payments consist of two parts: a payment toward the principal, or the amount you owe on the home, and an interest payment. A mortgage that is "interest-only" means that the borrower's payments will consist of only the interest and none of the principal on the loan. There is usually a specific term during which the borrower is allowed to pay interest only; this can vary, but it is typically about five to 10 years. Borrowers can, of course, make payments to the principle if they want to during the interest-only term.

Why Choose an Interest Only Loan?

Investors often choose interest-only mortgages, especially when they are going to flip a property. This option gives them the opportunity to purchase the building with a minimal investment, while turning it over quickly. Some savvy homeowners may also be able to create a bigger cash flow by investing their money rather than using it toward paying down the equity in their own home. It makes sense to build wealth, rather than make payments toward the principal on the mortgage. Many small business owners also choose interest-only options, believing that they will create a higher return on their income by investing in the business rather than a home. Buyers who are paid on commission, earn money seasonally, or receive a yearly bonus may choose interest only mortgages, making payments toward the principal to "catch up" whenever they get a lump sum payment. And interest-only loans are attractive for buyers who wish to obtain a second home with as little investment as possible.

What are the dangers Of Interest Only Loans?

An article in Forbes.com(http://www.forbes.com/services/2005/12/06/interest-only-mortgages-cx_lm_1207mortgage.html) explains the dangers associated with interest only loans, which mostly fall on individual borrowers. By not paying any principal at all, a borrower or what end up paying a lot more in interest later on -- so much that, overall, the loan isn't worth it. Many borrowers make a mess of their interest-only mortgage by assuming that they will invest the money that they aren't putting into their home -- and then they don't. Purchasing votes, cars and other luxuries are much too tempting. Other borrowers lose out when they find themselves out of a job, or find that due to market conditions the home has lost value during the time that they have not been paying into their equity. And of course those who haven't made any equity payments, haven't seen a rise in value, and do not have any savings for a down payment will be stuck, unable to sell the home because they don't have a way to buy a new one.

An interest-only loan can be just right, especially if the interest rate is low and is offset by tax deductibility. Those who are frugal with their money and who will invest the difference between the interest-only and an amortizing mortgage will benefit the most from this type of loan. It is important before selecting an interest-only mortgage to make a plan for what happens at the end of the 5 or 10 year term. This way, buyers protect themselves from being stuck with a home they cannot sell and do not want.

Tanya Davis is a freelance writer living in Tennesee.