Interest-only loans were all the rage at the height of the 1990s McMansion craze. People who had no business getting residential mortgages were able to secure interest-only loans and the lower monthly payments they are known for. On the other hand, traditional mortgage loans amortize interest for the entire term. So what is the difference?
Before explaining how all this works, it is worth noting that interest-loans were pretty much removed from the residential mortgage market with the 2008/2009 housing crash. You can still find them in small pockets here and there, but interest-only loans are now largely the domain of hard money and private lenders. That is not a bad thing, by the way.
Amortized Interest Loans
A loan with amortized interest is one with monthly payments that include both interest and principle. A traditional mortgage is the perfect example. Let us say you have a mortgage with an annual interest rate of 6%. That means with every monthly payment you are paying interest at a rate of 0.5% of the total amount owed at the start of the loan year. The rest of your payment goes to principle, escrow, and mortgage insurance.
Because every payment includes some money going toward principal, you owe less at the start of the second year. Your monthly interest payments for that year amount to the same 0.5% of the total amount due. So over time, more of your monthly payment is going toward principal and less to interest. But because interest is being calculated annually and you are paying it over the entire loan term, you could be paying hundreds of thousands of dollars in interest on your mortgage.
Interest-Only Loans
An interest-only loan is one for which monthly payments go only toward interest. Using the previous example, your monthly payments would consist of only the 0.5% interest per month. You would have to pay the entire principle with your final payment at the end of the term.
Hard money loans are the perfect example here. Let us say a real estate investor borrows $500,000 at an annual rate of 10%. We will also keep the term at 12 months just to make the math simple. His total interest would equal $50,000 spread out over 12 monthly payments. He would be paying just over $4,000 per month.
His monthly payments are lower because he’s only paying interest from month-to-month. But he does have that balloon payment due on the final month of his loan.
Which Option Is Better?
Now the big question: which option is better? That depends on the borrower and his financial needs. As the 2008/2009 housing crash proved, interest-only loans are not a good idea for residential home buyers. Unless a home buyer he is purposely setting aside money every month, coming up with a balloon payment at the end of the term proves very difficult. And if you are setting aside money every month, why not just get a traditional amortized mortgage instead?
Interest-only loans are a good choice for real estate investors, businesses, and others with access to cash and a willingness to go with a short term. How short? Salt Lake City-based Actium Lending says typical terms on hard money loans are 6-24 months.
The typical hard money lender doesn’t need a 30-year financing package. Having smaller monthly payments is better because it helps maintain cash flow. In the meantime, the borrower has a reasonable exit plan to pay the principal at maturity.
Now you know the difference between amortized and interest-only loans. They both serve distinctly different borrowers.