The Ins and Outs of Interest-Only Loans

Lenders have options when structuring loans. For example, mortgage loans are almost always structured as amortized loans with payments spread out over decades. Meanwhile, hard money loans tend to be structured as interest-only loans with terms of three years or less.

Interest-only loans packaged as residential mortgages are hard to come by these days. They were rather popular in the subprime market during the years leading up to the 2008 housing crash because they were easy to come by and pretty affordable on the front end. But changes instituted after the housing crash all but put the kibosh on interest-only loans for residential purchases.

How Interest-Only Loans Work

Also known as balloon loans, and interest-only loan accommodates two separate types of payments: interest and principle. For the entire life of the loan, the borrower’s monthly payments cover only the interest. Loan principle is due in one lump sum at the conclusion of the term.

As previously stated, interest-only mortgages are hard to come by these days. Most loans of this type are either hard money real estate loans or bridge loans for business needs. They are not offered in the residential market because it is just too risky for lenders and borrowers alike.

Lower Monthly Payments

An interest-only loan’s main selling point is low monthly payments. That explains why they were so popular as residential loan products in the 1990s and early 2000’s. People unable to buy homes using conventional loans could get financing through an interest-only product. Unfortunately, that led to a lot of people buying houses even though they could not truly afford to do so.

These days, interest-only loans remain attractive because of their low monthly payments. Whether it is an investor looking to purchase a piece of real estate or business looking to restructure its debt, limiting monthly payments to interest alone frees up valuable capital for other purposes.

Good for Lenders

Though it may seem odd, interest-only loans are actually good for lenders. Actium Partners, a Salt Lake City hard lending firm, explains why.

According to Actium, requiring clients to make monthly interest payments protects interest against default. Consider a hard money loan with total interest payments of $25,000. Every monthly payment represents a certain portion of the total interest the lender collects. Even if the borrower defaults, the amount of interest already paid will not be lost.

In the meantime, the lender can still repossess the borrower’s collateral and sell it to recover the principle amount. By going with the interest-only model, the lender reduces its risk by protecting interest payments against default.

Interest-Only Loans Cost More

In addition to the balloon payment at the end of the term, interest-only loans have another downside: they cost more. Interest rates can be several percentage points higher, and lender points and fees tend to be higher as well. It is all about managing risk.

Interest-only loans are riskier for lenders. There is always the risk that a borrower will not have the cash to make their principle payment at the end of the term. So to protect against that risk and cover any expenses that might arise as a result of default, lenders charge more. It is the nature of banking.

You now know the ins and outs of interest-only loans. They were all the rage in the subprime mortgage market a couple of decades ago, but no more. Today’s interest-only loans are primarily the domain of hard money lenders funding real estate transactions and bridge loans. That’s probably for the better in light of so many home buyers being trapped by the balloon mortgages of the past.