by Matthew Perry
(last updated February 21, 2009)
Interest-only loan options are awesome for some people, but not so good for others. You get a regular loan, but with the option of not paying on the principle of the loan (the amount of money you borrowed) for a set number of years, usually between five and ten. As a result, your monthly payments are just the interest on your loan.
This arrangement sounds really good at first, but the consequences of lower monthly payments may be more than you realize. If you pay only the interest on your loan, you still have a sizable payment every month because interest payments are highest at the beginning of a loan, and the principal, which is the amount you actually owe, doesn't go down. To make up for the time when you are only paying interest, you will have extra high payments when the interest-only term ends.
That makes them sound horrible, doesn't it? Interest-only loans do have their uses. If you can't make the payments on a standard loan at the moment you want to buy a house, perhaps you can make the smaller initial payments on a loan with an interest-only option. This would allow you to get a bigger loan, buy a more expensive house, and possibly cut out an expensive 'house swap' (getting your dream house first instead of moving into a not-so-dreamy house, saving up, and moving again). Investors may also find something to love about interest-only loans. The money that would have been paid on the principle can be invested in ways which generate more money, which can make up for the extra interest payments.
The time when interest-only loans make the most sense is in a booming real estate market. If house prices are going up, and you anticipate them rising steadily for three or four years, then you interest-only becomes very attractive. Why? Because the idea would be to sell your house in three to four years and cash in on the appreciation in your home's value, without the need to make large payments during that time.
Interest-only loans can be dangerous if you don't have immediate prospects for higher paychecks, better investment options, or higher home prices. In most cases, it's better (or at least smoother) to begin paying the principal on your loan immediately, so you are at less risk of defaulting on your loan.
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