Interest-only loan

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An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.

1 US interest only mortgages
2 UK interest only mortgages
3 Canadian interest only mortgages
4 From an investor's perspective
5 See also
6 References

[edit] US interest only mortgages

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.^[1] In other words, if a borrower had a thirty-year mortgage 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 repayments (in the interest-only period) are substantially lower than the later repayments. This enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they 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, one is essentially renting the house since none of the principal loan decreases. The two great disadvantages are that in many states one has to pay property tax and purchase mandatory property insurance.^[2]. On the other hand, the owner is still gathering appreciation, even if they aren't paying down equity against their loan, and there are many other tax advantages to home ownership not available to renters. In cases of aggressive appreciation (e.g. "flipping" homes), a 100% mortgage-to-value interest-only loan may also be able to be converted to a conventional mortgage with a more favorable mortgage-to-value loan, resulting in an overall lower payment.

[edit] UK interest only mortgages

Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest-only loan with an endowment policy, the combination being known as an endowment mortgage. Since the poor stock market performance of the late 1990s, endowment mortgages have become unpopular.

[edit] Canadian interest only mortgages

Some interest-only mortgages in Canada allow the borrower to pay interest-only, principal and interest, or even principal and interest plus 20% extra. An interest-only mortgage in Canada can be combined with corporate bonds in a Registered Retirement Savings Plan (RRSP) where the plan holder receives a tax deduction, tax deferral, and compound interest.

[edit] From an investor's perspective

Interest-only loans are sometimes generated articifially from structured securities, particularly CMOs. A pool of securities (typically mortgages) is created, and divided into tranches. The cashflows that are received from the underlying debts are spread through the tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally created in tandem with a principal only (PO) tranche. These tranches will cater to two particular type of investors, depending on whether the investors are trying to increase their current yield (which they can get from an IO), or trying to reduce their exposure to prepayments of the loans (which they can get from a PO).

Many homeowners saw the values of their homes increase by as much as 4 times its price in some markets in a 5 year span in the early 2000s. Interest-only loans helped homeowners afford more home and earn more appreciation during this time period.^[3]