What is an "interest-only" loan? | Consumer Financial Protection Bureau (2024)

FAQs

What is an "interest-only" loan? | Consumer Financial Protection Bureau? ›

An interest-only mortgage is a loan with scheduled payments that require you to pay only the interest for a specified amount of time. An interest rate on a mortgage loan is the cost you will pay each year to borrow the money, expressed as a percentage rate.

Interest-only loans. Loan in which the borrower pays interest each period and repays the entire principal amount at some point in the future. - if there is just one period, then it is the same as a pure discount loan.

Example of an interest-only mortgage

Say you obtain a 30-year interest-only loan for $330,000, with an initial rate of 5.1 percent and an interest-only term of seven years. During the interest-only period, you'd pay roughly $1,403 per month.

Cons of interest-only loans

Payment shock: Once the interest-only period ends, the monthly payments will increase as you start paying both principal and interest. This can lead to payment shock, especially if you have not prepared or budgeted for the higher payments.

While an interest-only loan may sound appealing for people looking to keep their payments low, it can be more difficult to get approved and is typically more accessible for people with significant savings, high credit scores and a low debt-to-income ratio.

With an Interest Only loan you choose to make payments that only cover the interest amount (for a set period). Interest Only payments are lower than if you were paying both the Principal and Interest components, however your loan balance isn't reducing.

With this type of loan, you only pay interest on the amount you use. Best of all, you do not need to use your home or other personal assets as collateral to ensure repayment of the loan. The time period that you are allowed to borrow is called the draw period and is typically 7-10 years.

Find out more about interest only home loans

An interest only home loan means you only pay the interest component, not the balance (or principal component).

How long can you pay interest only on your mortgage? ›

There are limits to how long you can have interest only periods – the maximum interest only period at any one time is five years for owner occupiers and 10 years for investors (credit criteria applies). Interest only is not available in the last five years of your loan.

First, if you take out an interest-only mortgage, you will not gain any equity in your home (beyond the equity of your down payment) until you begin principal payments. Home equity is astoundingly important for your financial future. Equity is the money owed to you should you sell or refinance your home in the future.

Thoroughly assess your financial situation, risk tolerance and long-term financial goals. Because of the tax benefits offered by interest-only loans, they're often viewed as a good option for investors, but they might not necessarily be the best choice for a first-time home buyer.

With an interest-only loan, the borrower's regular payments include only interest, not the principal amount of the loan. A line of credit is a good example of an interest-only loan. Because there are no principal payments, the monthly servicing requirements are low.

If you are buying to let, an interest-only mortgage can be more convenient, as it keeps your costs lower, and when the term expires, you can just sell the property to repay the loan.

Can I make extra repayments with an interest-only home loan? Yes. Whether your home loan is on a fixed or variable rate, you can make extra repayments into the loan account.

An interest-only mortgage is a home loan that has very low payments for the first several years that only cover the interest owed — not the principal. These lower initial payments may last for as long as 10 years, but after that you're required to start making payments toward the principal balance.

An interest-only mortgage offers lower monthly payments, but you must pay off the loan in full at the end of the loan term, and they tend to cost more overall. While repayment mortgages may be more expensive each month, they allow you to pay off your mortgage in full and generally cost less throughout the loan.

Interest-only mortgages are better suited to borrowers with lots of cash in reserve; borrowers who see their income significantly rising in the near future; and those disciplined enough to redirect income spikes toward paying down the principal.

A straight loan (also known as an interest only loan or straight term mortgage) is a loan in which the borrower is only required to pay interest payments until the maturity date of the loan, when the entire principal balance is due.