Interest Only Loans

Interest-only loans are loans where the borrower pays only the interest on the principal balance for a set term –typically five to ten years- at the beginning of the loan term. After the end of the interest-only period, the principal balance is then amortized for the remainder of the loan term. During the interest-only period, borrowers are essentially renting their own home as they are paying no principal down at all.

Borrowers choose this type of loan in order to get lower payments initially. Generally, interest-only borrowers expect that their income will rise significantly during the interest-only period, thereby enabling them to make the larger payments or afford to refinance a more manageable amortized loan at a later date. They may also benefit -if their home is located in an area where home values appreciate aggressively- by being able to “flip” the home.

Example:

  • The owner buys the house for $1,000,000 with $100,000 down and a $900,000 mortgage.
  • The owner pays 8% interest on the $900,000 loan for 10 years.
  • The house appreciates 12% annually.
  • At the end of ten years, the owner will have paid $720,000 in interest but will have $100,000 of paid-in equity plus the house will be worth $2.7M.

+$2,700,000 Sale Price
-$900,000 Loan Principal Due
=$1,800,000 in Capital Gain
-$720,000 in interest payments over the ten years
=$1,080,000 Net gain on investment (not including expenditures for property tax, insurance, closing costs, or home repairs)