An interest only home loan gives you the option to pay just the interest on a home loan during a specific period. In the case of a home equity line of credit, the most common loan that only requires interest payments, the period lasts for 10 years. After that, you enter the repayment period, which your loan becomes fully amortized and you make principal and interest payments.
The interest only loan obviously provides you with a lower payment at the onset of the loan. It makes it much easier for you to afford. However, the repayment period comes eventually. In other words, you have to pay the principal of the loan off at some point. Knowing the risks involved with this loan can help you make the right decision for your situation.
You Don’t Gain Equity With an Interest Only Loan
When you take out a home loan, you borrow against the home’s equity. As you pay the principal down, though, you increase your equity once again. In the case of the interest only loan, you don’t pay any principal. Let’s say the period which you only owe interest lasts for 10 years, that’s 10 years of principal payments that you lose.
Eventually, you’ll gain the equity back, but it could be much further down the road than if you made regular interest and principal payments. Of course, you have the option to make principal payments even during the interest only required payment period, but you’d have to make regular principal payments in order to gain sufficient equity back.
Without the equity, you can’t borrow against your home in the future. Let’s say you have a home equity line of credit. You won’t be able to reuse that line of credit unless you pay the principal back. If you wait until the repayment period, the benefit of the HELOC is eliminated and you are stuck with regular mortgage payments consisting of principal and interest.
You May Land Upside Down on Your Loan
Without paying down any principal on your loan, you could land upside down on your loan. This means you owe more than the home is worth. There’s no way to predict what a home’s value will do in the future. If values drop, yet you still owe the same amount of principal you borrowed in the first place, you could be upside down or underwater.
While this isn’t the end of the world if you plan on staying in the home, it makes it hard to move. If you sold your home for what it’s worth, you could end up owing more than you made in the sale. You’d take a loss rather than a gain on your real estate investment.
You May Not be Able to Afford the Principal Payment
Qualifying for the interest only loan usually requires a lender to ensure that you can afford the fully amortized loan in the future. But, if you don’t fully evaluate the situation, you may not realize the full implication of the principal plus interest payment. Again, since you can’t predict the future, you don’t know what your income will be like when the principal payments become due.
If you can’t afford the principal payment, you risk defaulting on your loan. If you miss enough payments, the lender can start the foreclosure process on your home. You then put your home at risk for loss because you can’t afford the principal payments.
The interest only loan is not as common as it used to be and for good reason. There’s something to be said about making principal and interest payments each month. If you end up in a bind and need the equity in your home, it will be there for you. All you had to do was make small principal payments each month. Making say $500 payments each month is a much better option than forking over thousands of dollars to deal with an emergency. That’s what the equity in your home can do for you – help you get out of an emergency. It can also serve as income during your retirement.
Think long and hard before taking out a loan that only requires interest payments. Consider your other options and compare the payments to see just how affordable a principal and interest loan may be now rather than later.