Interest-only loan
An interest-only loan is a loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period. At the end of the interest-only term the borrower must renegotiate another interest-only mortgage, pay the principal, or, if previously agreed, convert the loan to a principal-and-interest payment loan at the borrower's option.
Economic effects
Interest-only securities are sometimes generated artificially from structured securities, particularly CMOs. A pool of securities is created, and divided into tranches; the cash received from the underlying debts are spread through the tranches according to predefined rules. An Interest-only security is one type of tranche that can be created, it is generally created in tandem with a principal-only tranche. These tranches will cater to two types of investors, depending on whether the investors are trying to increase their current yield, or trying to reduce their exposure to prepayments of the loans. The investment returns on IOs and POs depend heavily on mortgage prepayment rates and permit investors to benefit from different prepayment expectations.Many U.S. markets saw home values increase by as much as four times in a five-year span in the early 2000s. Interest-only loans helped homeowners earn equity appreciation and thus be able to afford larger or more valuable homes during this time period. However, interest-only loans contributed greatly to creating the subsequent housing bubble where variable-rate borrowers could not afford the fully indexed rate or full principal-and-interest payments. Interest-only loans come with risks for borrowers and broader housing market stability when house prices drop as the outstanding mortgage can be larger than the value of the house.
By country
United States
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 loan 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 payments are substantially lower than the later payments. This gives the borrower more flexibility because the borrower is not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase his salary substantially over the course of the loan to borrow more than the borrower would have otherwise been able to afford, or investors to generate cashflow when they might not otherwise be able to. During the interest-only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that applies to principal is significantly smaller than the portion that applies to interest in the early years.Interest-only loans represent a somewhat higher risk for lenders, and therefore are often subject to a higher interest rate. Combined with little or no down payment, the adjustable rate variety of interest-only mortgages are sometimes indicative of a buyer taking on too much risk—especially when that buyer is unlikely to qualify under more conservative loan structures. Because a homeowner does not build any equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time the borrower is ready to either sell the house or refinance. The borrower may find themselves unable to afford the higher regularly amortized payments at the end of the interest-only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.
Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts such as Suze Orman advise against interest-only loans for which a borrower would not otherwise qualify. The types of interest-only loans that rely on home appreciation would be negative amortization loans, which most financial institutions discontinued in mid-2008.
A study published by the Federal Reserve Bank of Chicago before the 2008 financial crash claimed that most Americans could benefit from funding tax-deferred accounts rather than paying down mortgage balances. Homeowners sometimes use interest-only loans to free up monthly cash to fund retirement accounts. 3.4 million households don't contribute at all to their retirement but do accelerate the paying down of their mortgages. "Those households are losing from 11 to 17 cents for each dollar they put into a faster mortgage payoff", per a Chicago Federal Reserve study reiterated in the Chicago Tribune.