Calculating Interest-Only Payments
This calculator can be used to estimate payments and saving achieved through interest-only loans. The calculator needs a total of three inputs, including:
- The annual interest rate charged on the loan, which may not be the same value as the APR since fees associated with the loan are factored into the APR
- The term of the loan, which is the total number of years over which the loan will be outstanding
The calculator then provides the user with seven outputs via three sets of data:
- The monthly payment if the loan was a conventional loan (also referred to as a conforming loan), the monthly payment for an interest-only loan, and the monthly saving achieved by taking out an interest-only loan
- The total savings associated with the interest-only loan over the life of the loan
- The total amount of interest paid with a conventional loan compared to the interest-only loan
Interest-only loan arrangements
With an interest-only loan, the borrower is only responsible for paying the finance charges on the loan and not repayment of principal. For this reason, the outstanding balance of the loan does not go down over time as it does with a conventional, or conforming, loan. While this concept can apply to personal loans, it is more common to find this type of offering associated with home loans, or mortgages. The biggest advantage of these loans are their relatively low monthly payments; however. there are some pros and cons worth noting:
- Lower monthly payments compared to conventional loans
- Interest rates on these loans are oftentimes lower than those for longer term loans. Interest-only loans have typical durations of five to ten years
- The funds saved by not paying down the principal of the loan can be used to fund higher return investments than a home
- There is no building of equity in the home over time
- At the termination of the loan, the homeowner may have to refinance the loan
- In a declining housing market, it may be difficult to find a lender willing to write a loan if the home’s value had dropped to a point where the owner has very little equity in the home
One factor to also note is the interest paid on an interest-only loan will always be higher than with a conforming loan. For both loan types, the monthly payment stays the same over the life of the loan. But since the conventional loan is also paying down the loan’s principal, less of the payment is allocated to the financing charges and more to principal over time. Since this does not happen with an interest-only loan, the total finance charges will always be higher.
Why interest-only loans?
Homeowners may be attracted to interest-only loans the same way they are to balloon loans. Not everyone that buys a home considers it their “forever home.” They may have plans to expand their family and need more bedrooms in the future. Or the primary wage earner may have accepted a new job with their employer that requires them to live in a new geographic region on a temporary basis. If a buyer purchases a home and they intend to move in less than ten years, then an interest-only loan may be their best option since the commitment to the home is minimized and the home is sold before the need to refinance.