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Benefits and drawbacks of interest-only loans

Benefits and drawbacks of interest-only loans

What are interest-only loans? How can borrowers maximise their benefits without falling prey to the financial dangers they may bring? Find out more about interest-only loans with this quick guide.

What are interest-only loans? How can borrowers maximise their benefits without falling prey to the financial dangers they may bring? Find out more about interest-only loans with this quick guide.

What are interest-only loans?

With interest-only loans borrowers repay the interest portion only on the loan in a predetermined period of time—generally from five to ten years. By the end of this period, the principal amount (or the original capital amount - say $10,000 if it was a $10,000 loan) owed gets re-amortised over the remainder of the set loan term and payments get subjected to appropriate adjustments.

Many people find interest-only loans attractive, especially when they are borrowers without a traditional source of income or when they are debtors who expect an increase in their earnings.

Interest-only loans are appealing to borrowers since most want a lower monthly repayment cost t and offer flexibility in paying the principal whenever they receive a commission, bonuses, and any other similar additional income.

Interest-only loans are beneficial to borrowers who expect a dramatic increase in their earnings or income. The lower monthly repayment feature offered by interest-only loans are suitable for both personal and financial situations.  If their income rises they have to manage a much larger repayment cost.

Borrowers must consider both advantages and disadvantages of interest-only loans to decide whether it suits their financial needs and situation..

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Benefits

The advantages of interest-only loans include:

  • Freeing up money
  • Keeping costs low
  • Acquiring a more expensive property/asset

Freeing up money

Interest-only loans require lower payments, giving borrowers discretion on how and where to put one’s money. Some invest funds in businesses or other financial ventures. Some place money on monthly mortgage payments, similar to standard payment made towards full amortisation.

Some make improvements and/or other similar expenditures to their property, as most cases of house-flipping loans tend to be interest-only.

Keeping costs low

Some people choose interest-only loans because it is the only borrowing arrangement they can afford. If this is a personal circumstance, then it’s easy to understand how hard it is to choose an inexpensive property while still facing financial troubles after coming short on monthly rent/payments.

Choosing an interest-only loan can considerably lower costs and other similar expenditures.

Interest-only loans work well for individuals expecting irregular income because monthly obligations can be met at a much lower cost and allows making large lump sum payments to reduce the principal cost.

Additional payments made against the principal results in a lower amount of the required payments for the succeeding months

Acquiring a more expensive property/asset

The ability to purchase a more expensive property, and afford all financial obligations with a fixed-rate mortgage arrangement is a benefit of interest-only loans.

Lending institutions or creditors calculate and determine how much can be borrowed based on the average monthly income and employs a debt-to-income ratio. Because required payments are considerably lowered, the allowed borrowing amount becomes significantly larger.

Drawbacks

Possible disadvantages that interest-only loans may include the following:

  • Upside-down risks
  • Absence of equity
  • Servicing a debt and putting off what’s certain to come

Upside-down risks

When a property such as a family home, loses significant value after completing its purchase, borrowers might face the possible reality of owing more to it before actually selling it for a good price. It is also known as underwater risk.

Absence of equity

An interest-only loan does not encourage building equity on a property. It will be difficult using home equity loans in the future, especially when in need of more cash for upgrades and similar circumstances.

Servicing a debt and putting off what’s certain to come

Borrowers can fall prey into servicing a debt as paying only the interest can make them forget the exact amount of the money owed in the loan (as principal). that This means the loan will cost more than the initial amount owed.

It is important to thoroughly understand one’s personal and financial situation and circumstance before finally deciding whether to take out an interest-only loan. Consult with and engage the services of a trusted lawyer and/or financial adviser with proven expertise on loans to ascertain one’s financial plans and decisions.

Benefits and drawbacks of interest-only loans
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