Interest Only Loans

Ever heard of the payment of interest only and no repayment of the principle amount? Amusing, isn't it? It's true, certainly having a catch. The interest only loan is a loan where the interest amount is paid in installments till the maturity date. However, the principle amount remains fixed.

By the end of the term of interest only loan, one finds that those installments covered the principle amount along with the interest and nothing is to be paid now. The borrower pays only interest for a set term, which may range to 5-10 years in United States. After this term gets over, the principle amount gets amortized.

To clear the picture here is an example; if a person has raised loan for 20 years, and the interest payment is made in 7-year installment. Now, the balance principle is converted into installments for a period of next 13 years so as to get the full repayment.

Different Features of Interest Only Loans

As such interest only loans features different terms for each country. These loans are scheduled in various regions like US, UK, Canada and so on. Interest only loans carry an advantage of lower early payments than the latter, which lends the borrower a satisfaction to earn enough to pay heavy bucks. Moreover, it adds to the flexibility of interest payment first than the principle payments.

During the interest only payment term the principle amount is not reduced until the borrower pays extra amount (apart from the interest amounts) towards the repayment of the principle. Conventionally, the portion of payments towards the repayment of principle amount is very less in early years. These early years however are the interest only years.

Basically, interest only loans posses higher interest rates to compensate the high amount of risk bearing of the lenders. The low or absolute nil down payment along with adjustable rate (ARM) system, witnesses the extra amount of risk taken by the money provider. It turns out to be disastrous when the debtor is unlikely to qualify the more reserved loan policies. This kind of loan rising is not made for all.

It generally harms the person in need of home loan, as the home does not provide any extra income to the buyer unless he plans to sell it, and hence, it gets tougher to pay high interest rates along with the increasing amount of installments with the principle repayment term.

Studying the UK interest only system, it shows the popularity of these loans. In 1980's it was the common system to buy houses and sell those with at the end of the repayment term. These were combined with an endowment policy naming it endowment mortgage as a whole. The mis-selling and the failure of endowment policy resulted in the unpopularity of these loans.

Even in Canada, the borrower has to pay interest only (interest and principle) along with 20% extra. The loan holder receives a tax-deduction, tax deferral and compound interest.

Interest only policy when studied from the investor's view provides a whole new perspective. These loans are some times artificially created, particularly in collateralized mortgage obligation's (CMO). CMO's are financial debt vehicles that are created for a special purpose and are totally different from the entity, which has created it.

Investors in CMO's buy bonds buy the shares issued by the entity and receive the payments accordingly. The cash, which is received through these loans, are then spread through pre-defined rules. This technique caters to the two different needs of the investors.

  • Firstly, to the investors who are trying to increase their current yield
  • Secondly, to the investors who are trying their exposure to the other loan repayments

Hence, interest only loans are not only a way to enhance financial position by making easy repayments and investing the money accordingly but also help investors to get along their investments in a better way and synchronized way.