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How Interest-only Loans Work

Choosing an Interest-only Loan
Some people invest in the stock market with the money they save from an IO loan.
Some people invest in the stock market with the money they save from an IO loan.
Mario Tama/Getty Image News

The lower initial monthly payments of an interest-only loan are good for people who anticipate an increase in their income in the coming years. Having the option to pay as little as possible initially when you know a pay raise or promotion is on the horizon can be a real asset.

They're also beneficial for those who have fluctuating income. The IO loan option brings the flexibility to pay only the minimum payment during the lean months, or to pay extra when you have more disposable income. The extra payment is applied to the principal without penalty, lowering the amortized payment you'll be making once the IO period is up. If you have an IO loan, it's a good idea to chip away at the principal whenever you can. If you don't, you may suffer from "payment shock" once the loan is recalculated.

Another advantage to the IO option is that you're able to get more house than you could with an FRM. A common practice for first-time home buyers is to begin with a "starter" house, then sell it for profit after it appreciates. At this point they're able to get a larger second home. The lower initial term of an IO loan can allow you to skip the starter house and go directly to the larger house.

A homeowner that's wise in his or her investments might also benefit from an IO loan. Greater cash flow allows for more money available for playing the stock market or investing in other moneymaking opportunities. In order for this to be successful, the return on your other investments must be more than your mortgage rate. If you have an IO loan at 6 percent and your investments are coming back at 10 percent, you're doing the right thing.

Credit cards and other high-interest debts can be crippling for a family looking to get ahead. Applying the disposable income your IO loan provides toward that debt is a great way to achieve financial freedom.

An IO loan may also be a good idea if you plan on "flipping" your home within the option period for a return on your investment. Using sweat equity to restore an older home is a great way to maximize your profits. The one factor that's most important here is that your house appreciates during this time. For a while, real estate was appreciating rapidly in the United States and house flippers were getting rich. The bubble has burst somewhat now and appreciation in most markets has leveled out or declined.

With all of these examples, fiscal discipline is the most important factor in order to be successful. If you don't have enough self-control not to use your extra cash for that vacation in the Bahamas, then you aren't maximizing the benefits of your IO option. You may want to avoid an IO loan if:

  • You aren't wise in your other investments.
  • Your income isn't expected to increase.
  • You aren't disciplined enough to pay on the principal.
  • Your home isn't expected to increase in value.
  • You feel the gamble on rising interest rates is not a good one.

It's important to do your homework and seek outside opinions from more than one financial adviser or mortgage broker. As with any commission-based industry, the integrity of your mortgage broker plays a vital role in the success of your plan. Some brokers will do anything to get you to sign on the dotted line. Do yourself a favor -- shop around, crunch the numbers and don't get carried away in the pursuit of your dream home.

For more information on interest-only loans, check out the links on the following page.

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