Personal Finance Advice

Interest-only loans can be a little tricky.  If you’re offered a loan with these terms from a lender it may seem like a really great idea: make only interest payments monthly and pay down the principal balance when you can.  If you have a sporadic income, such as self-employment or a seasonal job where you work strictly on commission, this type of loan may be the best way you can pay your loan without having to pay too much each and every month.

Like all personal finance products, however, there is a chance for real problems with this type of loan. 

Here is how an interest-only loan works: You obtain a loan or line of credit that charges interest every month on the principal balance.  The amount of interest charges you pay every month depends on what the interest rate is and the amount of the principal balance, but the lower your principal balance the less you will pay in interest charges every month.

When you send in your monthly payment you are only required to pay the monthly interest charges, and this is usually a small amount compared to what you would pay if you were making a full payment on the interest and principal of the loan.  When you make the minimum payment you’re only paying the interest, not the principal, so this means that the principal balance stays the same and does not go down.  In other words, if you borrow $10,000 on an interest-only loan and then only pay the minimum payments for a year, you still owe $10,000 after that year.  That can be a pretty horrifying concept if you didn’t realize that this is how the loan works.

The best way to handle an interest-only loan is to make a commitment to making principal payments each and every month.  If you don’t do this then there will come a time when the amortization of the loan expires - also called the “balloon” - where the entire balance of the loan comes due, so unless you can refinance the loan you’re obligated to pay it off in full. 

If you have an interest-only loan because of sporadic income, try to balance out your principal payments as well as you can.  If you’re unable to make a principal payment one month because of low income, double up on the months when you have substantial income. 

Make sure you understand the terms of a loan before you sign any papers, otherwise you may wind up with a loan product that you don’t fully understand and that can get you into some financial trouble.