Are Interest Only Loans Good or Bad?

Loan Calculator

My Qualifier Plus mortgage calculator. I’ve had this bad boy for about 9 years now.

Are interest only loans good or bad?

That’s a great question. Actually, it’s kind of a trick question. Maybe even a little silly.

It is similar to asking whether lifted Chevy pickups are good or bad.

It’s a tough question to answer with a simple good or bad response because it really depends on your needs and goals. (What you’re trying to accomplish and where you are planning to go.)

So the better question would be, “Is an Interest Only loan the right option for me?”

Real estate loans with Interest-Only payments are certainly not the right fit for everyone.  With private money loans, however, the interest only option does make a lot of sense for many borrowers – especially on investment properties.

You just need to learn how the loan terms work so you can decide if it’s a good option for your specific situation. In this article you will learn how the interest-only feature works and how you can calculate the monthly payments on your own. (Without needing a mortgage broker to run the numbers for you.)

 

What is an Interest Only Loan?

The California Bureau of Real Estate provides this definition in their real estate glossary:

“A straight, non-amortizing loan in which the lender receives only interest during the term of the loan and principal is repaid in a lump sum at maturity.”

In simple English, it means that you make payments to the lender for only the interest that is charged on the loan. (Not the principal)

In the definition above, it also explains that an interest only loan is a “straight, non-amortizing loan…”

To understand what that means, you would also need to know what the words ‘amortizing’ or ‘amortization’ mean.  Here are two different definitions to explain amortization:

   Amortization

  1. The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time.
  2. The liquidation of a financial obligation on an installment basis.

You start off with an original loan balance, then you make regular monthly payments of principal and interest until the loan is eventually paid off. This is how most of the fixed-rate mortgage loans work. Car loans also work the same way.

 

Can You Make Payments Towards the Principal?

Yes, absolutely.

Even though you are only charged for the monthly interest due on the loan, you can still make extra principal payments when it is convenient for you.

In most cases, you won’t have any fees or penalties for making extra payments towards your principal. This fee is known as a prepayment penalty and is one of the 9 critical lending terms you need to learn about when considering a private money loan for your purchase or refinance.

If you do plan to make extra payments to the principal before the maturity date, consider following these several tips:

  • Write a separate check to be specifically applied for principal.
  • Make the dollar amount different from your regular monthly interest payment.  If your monthly payment is $2,500, you might send in a $3,000 or $5,000 principal payment. This will help avoid the check being confused for one of your regular payments.
  • Make a note in the memo section of the check: For Principal Only or To Be Applied to Principal Balance Only – something along those lines to make it clear what your intention is.
  • Make the principal payments large, round numbers such as $500, $1,000, $5,000 or $20,000.
  • Keep copies of your checks for your own financial records.

Now here are the reasons behind those suggestions:

  1. It keeps the accounting clean and simple for both parties (You and the lender)
  2. The different check amount avoids potential confusion.
  3. The private money investors prefer to be paid off in larger round numbers. (On interest only loans)

 

What are the Benefits of Interest Only?

Lower monthly payments – This is a big deal for investment properties. Lower payments mean increased cash flow from rental income.  Everybody likes cash flow.

Simple accounting – You know what your loan balance is, and the lender knows what it is. This makes it easy to calculate your monthly interest payment.

Your payments can be reduced – Here is the beauty of interest only. The interest is charged on the outstanding principal balance. When you reduce your loan balance, you also reduce your interest payment because the interest is now charged on a smaller principal balance.

And how would you figure out what your new monthly payments would be?

Funny you should ask…

 

How to Calculate Your Payment

Calculating your Interest Only payment can be done on any simple calculator. It is even easier if the calculator has a percentage button (%) on it.  But if not, don’t worry; any old calculator will work just fine.

In fact, this is so simple that you can even go old school with pencil and paper if you are mathematically talented.

You can figure out your payments in only 2 simple steps:

  1. Calculate the annual interest
  2. Calculate the monthly interest

To calculate the annual interest, you would multiply the loan amount by the interest rate.

Loan amount x Interest Rate = Annual Interest (in dollars)

To calculate the monthly interest, just divide the annual interest by 12 months.

Annual Interest ÷ 12 = Monthly Interest (in dollars)

Got it?

Here are two examples below to show you what it looks like in real numbers.

Example 1

Terms:

Loan Amount     $100,000

Interest Rate      12%

 

Calculation:

Step 1   $100,000 x 12% = $12,000

$12,000 is the annual interest charged on the $100,000

Step 2:  Now divide the annual interest into 12 months like this:

$12,000 ÷ 12 = $1,000

Your monthly interest is $1,000

Example 2

Terms:

Loan Amount         $250,000

Interest                   10%

 

Calculation:

Step 1   $250,000 x 10% = $25,000

Step 2   $25,000 ÷ 12 = $2,083.33

 

Note:  You will need a mortgage calculator if you want to calculate the payments on an amortized loan.  The calculation is more complicated to figure out principal and interest payments because it involves a math formula that is built into mortgage calculators.

You can find lots of free mortgage calculators online.  Just type ‘online mortgage calculator’ into Google and you’ll find plenty. I found a calculator on Bankrate.com that is very easy to use. (Link below)

http://www.bankrate.com/calculators/mortgages/mortgage-calculator.aspx

Better yet, you can now download free mobile apps for your smart phone. You’ll have a real estate financing calculator in your pocket or purse. This is the way to go!

The only downside is that the free versions all seem to have advertisements for lenders. The ads can be annoying, but you can’t expect too much from a free app.

I hope this information was helpful. If you have more questions or comments, please share your thoughts in the comments section below.

– Chris

 

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