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Interest Only Loans

Most interest only loans are adjustable rate loans, so, to better understand them, review the section on adjustable rate loans first. The big difference between a standard adjustable and an interest only is that, for a set initial period, the borrower is only required to pay interest. This period can be as short as 3 years or as long as 10 years. 

The mortgage payment is lower because the portion of the payment that pays down your loan has been eliminated. This is a great loan for somebody staying in a home for a short period of time, but you need to be aware that your payment will increase substantially when the interest only period ends. It is also a good loan for a household that has a high potential of substantial income increases over the next couple of years. It allows you to buy today what you will be able to afford in the future. Finally, it is a good loan for somebody that intends on paying down the loan in the next few years. 

Letís say that you have another home that hasnít sold yet, but you want to buy your new home now, or you are expecting a lawsuit settlement in the next couple of years. The interest only allows you to buy the new home, and then pay down the mortgage when the cash becomes available. Since the payment on the loan is interest only, and you have paid down the principal, the mortgage payment will automatically drop. This is because you would owe less after the principal reduction and an interest only payment is based on the balance of the loan, not the length of the loan. This is different then a regular fixed rate. Make a principal reduction on a fixed rate and your payment stays the same, but the time it takes for the loan to be paid in full shortens.

Understand, however, that not everyone will qualify for an interest only loan. The credit score requirements are stricter and the down payment requirements are higher. On most programs, the lender still qualifies you using the fully amortized payment, not the interest only payment. It is not a good loan for your average first time home buyer, but it does fill certain niches.