What is an Interest Only Loan?

Utilizing interest only loans can be quite valuable for borrowers who plan on refinancing or selling their properties several years in the future.

An interest only loan is a type of adjustable rate mortgage loan in which you make interest only payments for a set number of years, and after that you make principal and interest payments for the remainder of the loan term.

During the initial period, where you make interest only payments, your interest rate is typically fixed at a low rate.

For example, on a 5/1 I/O ARM, you would be making interest only payments for the first five years at a fixed interest rate, which is usually very low, and after these first five initial years, your interest rate would start adjusting once every year and you be paying principal and interest in your mortgage payment.

Because the interest will start to adjust and you will start to make payments of principal as well as interest after the initial fixed period, you can experience a payment shock after the initial fixed years, which means your mortgage payment will usually go up substantially.

For this reason, an interest only loan is really intended for homeowners who plan on refinancing again in the near future or plan on selling their property, before the initial interest only period elapses.

One final note I’ll make is that banks will typically offer initial interest only periods of 3, 5, 7 and even 10 years. Usually the more years the initial interest only period is, the higher the initial fixed rate will be.

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