Are interest-only loans a good choice?

Interest-only loans have become very popular in recent years. They provide a great opportunity to buy a more expensive home with a lower monthly payment, free up some cash or just keep your monthly obligations smaller. However, be carefully with this financial option because its risks can outweigh its benefits. 

First of all, it is important to understand the difference between the interest and the principal. Lenders give borrowers the money to purchase a house or any other big-ticket item for a fee that is spread out over the duration of the loan. It is the interest. The principle is the actual amount of the loan that you take.

With an interest-only loan, you pay only the interest on the principal during the set period of time - usually from five to seven years. The APR can adjust annually or be fixed for a while before becoming variable. At the end of the interest only period you either have to pay off the principal as a lump sum or make both principal and interest payments. 

Many people believe that an interest-only loan is a type of mortgage. In fact, it is an option that can be attached to any type of mortgage, for example HELOCs and equity lines of credit. There are also some other types of loans that come with interest-only payments for a fixed period of time, for example student loans. 

Interest-only loans have become popular due to several reasons. First of all, as you can guess, the payments are smaller than with a standard mortgage. And it is much easier to get approved for larger amounts with an interest-only mortgage than you could qualify for with a traditional mortgage.

However, financial experts don’t recommend interest-only loans for ordinary home-buyers who take out moderate-size home loans and don't have a strategy for investing the savings. This financial option is not meant for the long haul. 

Basically, interest-only loans suit: 

•    People who expect an increase in their income down the road. 
•    People whose income fluctuates. 
•    Investors who plan to flip the property. 

Keep in mind that just because you apply for an interest only loan, it does not mean that you can’t make payments toward your principal. You can pay extra when you have more disposable income. This amount will be applied to the principle, lowering the amortized payment you will have to make when the interest-only period passes. 

It is a good idea to chip away at the principle whenever you can. Otherwise, you can be shocked when your loan is recalculated. The monthly payment might double or even triple! That’s why many borrowers expect to sell their homes or refinance before the interest-only period passes. 

Among the other traps of taking out interest-only loans is the risk that the borrower will lose a stable source of income. If you don’t have money to pay off your debt, you can face foreclosure. Another danger is that your house can lose its value. The property market is falling, and many people sell their property at a loss.

Taking these facts into consideration, interest-only loans are not a good choice if:
•    You will not have higher income. 
•    Your home will not increase in value. 
•    You don’t have money to reduce the principle. 
•    You don’t like the idea that your monthly payment will skyrocket down the road. 

If you decide that interest only loans fit your needs and style of life, it's important to do your homework. Like regular mortgages, interest-only loans come in many different flavors, so it pays to shop around. Look for outside opinions from several financial advisers or mortgage brokers to make a well-educated choice.