A 12-month interest-only loan is a short-term financing arrangement where the borrower makes payments covering only the interest charges for one year, without reducing the principal balance. This structure results in lower, temporary, initial monthly payments, often used for construction or, in real estate, to bridge to a sale.
Interest-only loans free up your cash flow. Since this type of mortgage is one of the most affordable ways to borrow money, you'll have the extra cash to pay your debts or invest in other projects while still owning a home. Interest-only loans offer you a tax break.
There are also risks involved with getting an interest-only repayment loan. For example, if your home or investment property declines in value during the interest-only period, you could come out with no equity. Meaning, you may end up owing more than the property is worth.
Interest-only loans are most commonly used for mortgages. For example, if you borrow $400,000 at a rate of 6% for 30 years, your monthly interest payment would be $1,919.50 and your monthly principal payment would be $478.70.
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.
You'll need to be well-qualified to be approved for an interest-only mortgage. Banks generally look for borrowers who have: A credit score of 700 or more. A debt-to-income (DTI) ratio of 43 percent or less.
At the end of the term of an interest-only mortgage you will still owe the amount your originally borrowed. In an ideal world, when your interest-only mortgage ends, you'd have sufficient cash savings or investments to pay off the capital balance. But, unfortunately, this won't be the case for many borrowers.
Typically, lenders offer up to 75% of the property's value for an interest-only mortgage. This means that you'll need a deposit of at least 25%. As interest-only mortgages pose more of a risk for lenders than repayment mortgages, many lenders ask for a much higher deposit, such as 40% or 50%.
Let's take a closer look at six loan types that borrowers should approach with caution, or avoid entirely.
Pros. Lower repayments during the interest-only period could help you save more or pay off other more expensive debts. Short-term finance that covers the period between buying a new property and selling your existing property. A type of home loan for people who are building their own home.
With interest-only mortgages, you only pay off the interest on the amount you borrow. You use savings, investments or other assets you have (known as 'repayment plans') to pay off the total amount borrowed at the end of your mortgage term.
In summary. Interest-only ARMs offer a unique approach to home financing, giving borrowers flexibility with lower upfront payments and potentially more cash for other investments. However, they also carry risks, including interest rate changes and the potential for much higher payments down the road.
The Cons of Interest-Only Home Loans
One major risk is that your monthly payments could increase significantly at the end of the interest-only period when you are required to start paying both principal and interest. Additionally, if your property's value decreases, you could find yourself underwater on your loan — owing more than the property is worth.
You can pay off your interest only mortgage early, but there may be limitations to the amount you can repay without incurring an Early Repayment Charge (ERC), depending on your mortgage. Check your mortgage terms for more information on repayments limits or charges.
Like conventional loans, interest-only loans typically come with 30- or 15-year terms. But, because you're only paying interest at the beginning, you'll have a shorter amount of time to repay the principal. It's important to be sure you'll be able to afford to make higher payments once the interest-only period is over.
To qualify for an interest-only mortgage loan, you'll likely need:
You generally need a credit score of at least 620 to qualify for a conventional mortgage, though every lender is different. FHA loans, which are backed by the federal government, may be an option for individuals with credit scores as low as 500.