If you are thinking about purchasing a condo or a new home, you need to address one of the main elements involved in the buying process-financing. There are many types of loans you can get and several times as many lenders who will offer them to you at varying rates. An interest only loan is an example of one type of loan you can obtain. Here are the steps on how to get this type of loan, and most importantly, to decide if this loan structure is a good idea for you.
- What is an interest only loan? First of all, you need to know what an interest only loan is and what it entails. Most conventional loans are based on the mortgagee paying monthly installments that go toward both the principal balance and the interest. In an interest only loan, the borrower repays the interest only in equal installments. The principal is due in full at the end of the payment term.
- Who uses interest only loans? Wealthy clients often choose the interest only loans because they free up cash for investment purposes. Money that a client would be using to pay off principal in a conventional loan is now available to place in a maturing fund, a real estate property, or the stock market for gain. Some people with commission-based salaries choose the interest only loan because it allows them to make small payments in lean months, and larger ones when they have a fruitful season or earnings. Lastly, someone with a limited amount of income, but one that expects to see a significant increase in income may want to research the interest only loan. For instance, if you know you are going to get a large promotion, a higher paying job, or will have two incomes (marriage) in the near future, you may want to consider this type of loan.
- Pros. Interest only loans allow you to have a low monthly balance to pay until the end of the term of the loan. This frees up cash for other investments or for saving. They also allow you to buy a "lot more house" for your money, since the money you are not paying monthly can go toward the down payment.
- Cons. More important to you, perhaps, is when is an interest loan is NOT a good idea. If your interest only loan is for a long term (more than 5 years), and you are only paying the interest each year, you will pay more interest over the long run than you would in a conventional loan.
- Adjustable risk. Interest only loans are particularly risky when associated with Adjustable Rate Mortgages, or ARMS. Consider an interest only payment plan for 10 years at an initial rate of 4%, which resets every six months. At worst, the rate would climb up by 2% every six months and end at a maximum of 10% in the nineteenth month. The interest-only payment in month nineteen would be 150% higher than the initial payment. Using a mortgage calculator, you can see that the amortizing balance due in a a conventional mortgage would be only 82% higher. In this instance, there is a significant difference between the interest only and conventional mortgage.
- Market value. If you have an interest only loan on a home and the real estate market suffers during the course of your borrowing, you can build negative equity on your home. Interest only loans were huge in the 1920s because people could buy and live in a house, then refinance. When the stock market crashed, lenders switched to fully amortized loans and homes went into foreclosure.
- Prepayment penalties. Find out if your loan has prepayment penalties, meaning, if you pay money toward your principal or pay the loan off early, you will be charged a fee. If this is the case, consider rethinking the interest only loan. Typically these loans do not carry a penalty, but always double check.
- Refinancing risk. If you are a daring soul, you may consider the interest only loan under the condition that you will refinance midway through. In this scenario, you are banking on getting a better rate than you originated with-which, as you can guess, does not always happen. You could end up owing a lot more money if you cannot get an attractive rate.
- How to get one. If you've decided that the benefits of the interest only loan outweigh the negatives, you can get a loan from most any lender. Shop around and get a mortgage broker you like and who can provide you with a competitive rate for this type of loan. Mostly likely you will qualify for a loan; just make sure it is an attractive rate and that you feel confident of your ability to manage your money and your payments now, and at the end of your loan term.