With an interest only loan there is a set term during which the borrower has the option to pay only the interest due on the loan, causing the principal balance to remain unchanged. This feature is available on both adjustable rate mortgages (ARMs) and hybrid mortgages (i.e., those that combine the features of both a fixed and an adjustable rate mortgage).
Depending upon the particular loan product chosen, the interest only period typically ranges from three to ten years. Each month, borrowers have the choice of making the interest only payment, the full principal and interest payment or any amount in between. At the end of the interest only period, the loan balance is fully amortized over the remaining term and the borrower's payments will include both principal and interest.
Many people find these loans attractive for the following reasons:
In some cases they allow borrowers to qualify at the interest only payment, enabling them to qualify for a higher loan amount.
Borrowers who expect their income to increase over time appreciate being able to take advantage of the lower monthly payment option allowed during the interest only term.
Some borrowers like the flexibility of either making the full principal and interest payment or taking the difference between the full payment and the interest only payment due and directing it to the investment of their choice if the rate of return exceeds the interest rate charged.
For the majority of the interest only products offered, the borrower's monthly payment is determined by the current outstanding principal balance. Therefore, if a borrower makes a principal pay down during the interest only period, their monthly interest only payment (as well as the optional principal and interest payment) will be reduced accordingly. This feature appeals to borrowers that expect to receive large sums of money that they would eventually like to apply to their mortgage balance but who prefer that it reduces their monthly payment rather than the overall term of the loan. For e.g. this option may be attractive to borrowers who expect to receive a bonus, an inheritance, or those who have yet to sell their home, who anticipate receiving a considerable amount of funds once their prior home sells, etc.