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How Interest-only Loans Work

Deanie Canales

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An interest-only loan is a type of mortgage or real-estate equity loan in which the only thing the borrower has to pay for a period of time is the interest. The problem with these arrangements is that there actually is no such thing as an interest-only loan. Instead there are arrangements in which you can defer payment of the principal for a specific period of time.

The reason there is no such thing as an interest only loan is that you will have to pay the principal - the amount you borrowed - back sooner or later. You can only defer repayment you cannot avoid it altogether. To understand this process you must understand how amortization works.

How Mortgage Amortization Works

A mortgage or real-estate equity loan is made up of two parts the amount borrowed and the interest. The principal is the amount of money borrowed and used. The interest is the cost of borrowing money, it includes the interest rate and other charges added for things like the insurance.

The amount the borrower pays back is a combination of the principal and the total amount of interest charged. This determined by multiplying the principal by the interest rate and adding the amount of interest to the principal. The monthly payment is determined by dividing this amount by the number of payments.

Interest Only Loan Arrangements

In an interest only loan the lender lets the borrower pay only the interest rate for a period of time. At some point he or she will have to start making payments on the principal. This arrangement is designed to make mortgages more flexible in order to make it easier for lower income people to afford housing.

Most interest-only deals give a person the option of not making payments on the principal for a specific period of time usually the first five years of the mortgage. The drawback to this is that the person will have to make higher payments at some point to pay back off the principal. Many of these arrangements also charge a higher rate of interest.

This is not a good deal for most people because they will end up paying more for the loan. They will not be saving money only deferring the payment to some point in the future. Some persons for example business owners without a stable income might benefit from this arrangement, persons with a regular salary would not.

How to Use an Interest Only Loan If you have an interest-only loan you should make principal payments if you can afford to even when you are not obligated to. That will reduce your debt load and make it easier to pay off the mortgage. It could also keep your interest payments lower.

If you are in an interest-only arrangement it might be a good idea to see if you could refinance it. If you have equity in your property you should be able to refinance and get a better deal. A traditional 20 or 30 year mortgage could have a lower interest rate and better terms so it will cost you less in the long run.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity , Retirement Annuity , and Income Annuity .


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