Interest-only loan
An
interest-only loan is a
loan in which for a set term the borrower pays only the
interest on the
Principal balance; the principal balance will remain unchanged. At the end of the interest only term the borrower may renew the interest-only mortgage, payoff the principal balance, or (with some lenders) convert the loan to a principal and interest payment (or
Amortized)loan at his/her option.
In the
United States, a five or ten year interest-only period is typical. After this time, the principal balance is
amortized for the remaining term. In other words, if a borrower had a thirty year
mortgage and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early repayments (in the interest-only period) are substantially lower than the later repayments. This enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford. Interest only loans were popular in the
1920s. Due to the economic downturn and lack of work for the average person, there were many foreclosures during the
Great Depression of the
1930s.
During the interest-only years of the mortgage, one is essentially renting the house since none of the principal loan decreases. The two great disadvantages are that in many states one has to pay a (1)
property tax and purchase (2)
property insurance which is mandatory.
Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the
United Kingdom in the
1980s and
1990s a popular way to buy a house was to combine an interest-only loan with an
endowment policy, the combination being known as an
endowment mortgage. Since the poor stock market performance of the late
1990s endowment mortgages have become unpopular.
Some interest-only mortgages in
Canada allow the borrower to pay interest-only, principal and interest, or even principal and interest plus 20% extra. An interest-only mortgage in Canada can be combined with corporate bonds in a
Registered Retirement Savings Plan (RRSP) where the plan holder receives a
tax deduction,
tax deferral, and
compound interest.
Interest-only loans are sometimes generated articifially from structured securities, particularly
CMOs. A pool of securities (typically mortgages) is created, and divided into
tranches. The cashflows that are received from the underlying debts are spread through the tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally created in tandem with a principal only (PO) tranche. These tranches will cater to two particular type of investors, depending on whether the investor is trying to increase their current yield (which they can get from an IO), or trying to reduce their exposure to prepayments of the loans (which they can get from a PO).
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Mortgages
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Endowment policy*
UK mortgage terminology*
Balloon payment mortgage
