Every loan has a declared rate of interest. The interest could be a fixed rate or floating. It could be a combination as well, fixed for a few years and then adjustable as per the prevailing lending rates in the market. All standard loans are re-paid over a period and every instalment has a bit of the principal which is the loan amount and a bit of interest. Most loans are designed in a way wherein more interest is paid in the first few months or years and towards the latter half of the term it is more of the principal amount being re-paid and less of interest.
During an interest-only period, scheduled repayments cover interest but do not reduce the principal. When that period ends, repayments usually switch to principal and interest over the remaining loan term, so they can rise substantially. Interest continues to accrue; it is not paid off before principal repayments begin.
Pros and Cons of Interest Only Loan
The Pros
- An Interest only loan is beneficial for those who are looking at lower monthly repayments. Since the principal amount is not being considered in the initial instalments, the interest is split evenly into a certain number of months don’t amount to as much as it would had the principal been taken into the calculations.
- An interest-only structure does not itself create a tax deduction. Tax treatment depends on how borrowed funds are used and individual circumstances; obtain tax advice. Interest only loans are often opted for by property investors and commercial property owners.
- Interest only loans help property investors who don’t intend to hold onto an investment for too long. Selling at a profit is not assured. Property values may fall, and sale proceeds may not cover the debt and transaction costs.
The Cons
- An interest-only period leaves the principal outstanding and can increase the total interest paid. Consider whether you can afford the later repayments and whether this structure suits your circumstances.
- It also doesn’t make sense to allow the lender to make all the profit and then to keep repaying the principal amount which can go awry if someone loses a job or incurs losses in business.
- Not every lender offers interest only loans so there are fewer options available.
