This is often an option attached to mortgages.
For example, if a home loan has a monthly payment of $500 consisting of $400 interest and $100 principal, then an interest only loan would only require the borrower to make a payment of $400.
This means that during any interest-only period, no matter how much money a borrower repays, the principal will continue to remain the same as the original loan principal.
This is because no portion of their payments are used to towards paying the principal.
There was a period of time when interest only home loans were the majority of mortgages in the market.
But because of a high rate of defaults, lenders started to turn to fully amortizing loans.
Advantages of interest-only mortgages
The rise of these types of loans was mainly due to demand.
There are some very good reasons why many investors and homeowners would like to use such loans.
A lot of home buyers take on as much financing as they can to buy as big a house as they can when buying a home.
This means that for many, the initial few years of the mortgage can be tough on their cash flow as they have yet to see a significant increment in personal income.
Triggering an interest-only clause can help them better manage their financial budgets.
And when the interest only period expires maybe 5 to 8 years later, they would be in a much stronger financial position to comfortably meet the debt obligations.
However, borrowers must note that once such a loan reverts to a fully amortizing mortgage, their monthly payments would increase to take into account the many years before when principal was not repaid.
Investors are usually very particular with how they leverage their money.
Because should a mortgage be at 5% and they are able to find investment opportunities that yield 10%, they would be crazy to repay the mortgage with their cash in the bank.
The goal is always to maximize the use of credit while using as little of their capital as possible.
With low capital, return rates can increase dramatically.
If the mortgage is at 5% and the borrower has other debts at 9%, it makes sense to delay the payment towards the mortgage and use those funds to repay the more expensive debts first.