A typical mortgage requires principal and interest payments. Each month, you pay a portion of your principal down, this leaves you with equity in the home. Interest only loans, however, do not require principal payments. You only pay interest on the amount of money you borrowed. The principal doesn’t become due until the repayment period.
We help you understand the process below.
How Much Did You Borrow?
The most common interest only loan is the home equity line of credit. With this type of loan, you get approved for a maximum credit limit. Let’s say it’s $50,000. You then have $50,000 in an account for you to use. It works much like a credit card. You can write a check or use your credit card to use a portion of the money. Let’s say you take out $10,000 of it. You would then owe interest only on the $10,000. The remaining $40,000 remains in the account.
If you decide to withdraw more funds from the $50,000 limit, you’ll pay interest on those funds as well. During the draw period, you only owe the interest payments. You do have the option to make principal payments, but you are not required to do so. Keep in mind, though, the more you borrow, the more interest you pay.
What’s the Term of the Interest Only Loan?
The next step is determining the term of the interest only loan. In the case of the HELOC, you pay interest for the first 10 years usually. After that time, the loan goes into the repayment period. You can no longer draw funds from the account. The draw period becomes closed. You then make principal and interest payments over a period of usually 20 years. The amount of principal you’ll pay would be higher than a 30-year amortized payment, if you didn’t make interest only payments.
Not every interest only loan occurs over the same period. It varies by lender and program. Make sure you ask the right questions and read the fine print. Ask the lender specifically how long the interest only payment period lasts. Also, ask if the rate adjusts at all during that time. Many HELOCs have a variable interest rate that allows the rate to change on a monthly basis.
Entering the Repayment Period
Once the interest only period ends, you enter the repayment period. This is when you must make principal and interest payments. If you neglect to pay the principal, the lender could mark your loan late. Once you hit 30-days late, it counts against you on your credit report. If you continually avoid making principal payments, the payment becomes 60 and 90-days past due. Once you pass 90-days late, most lenders will start foreclosure proceedings.
The good news is that if you make your principal payments, you’ll start gaining equity in your home. When you made strictly interest payments, you never gained any equity in your home. The principal balance remains the same. Once you start paying the principal down, though, you have more leverage for future financial options.
If you want to tap into your home’s equity again, you may be able to do so with a refinance. You may also use the equity to obtain a cash-out first mortgage that pays off your interest only loan. Then you would only have one mortgage payment you must make each month. The first mortgage is always principal and interest as the QM guidelines don’t allow for interest only payments any longer.
Selling a Home With an Interest Only Loan
The largest risk occurs if you need to sell the home. Since you never paid any principal of the loan down, you may owe more than the home is worth. If the home is worth less than what you owe, you may owe the bank money when you sell your home. Generally, it works the opposite. Usually the seller receives a check from the closing agent at the closing. The check is the difference between the sales price of the home and the amount owed to the lender to pay the loan in full.
An interest only loan may sound like a great choice at first, especially if you know your income may increase down the road. However, there are serious implications it can have on your financial future. Consider your options carefully, comparing a principal and interest payment to the interest only loan. You may find the difference is only a small amount that you can afford. It will work better for you in the long run if you have equity in your home and less worries about selling a home in a depreciating market.