Interest-Only and Balloon Loans
An interest-only loan is a twist on the variable loan theme. With an interest-only loan, you pay only the interest due on the loan (and no money towards the principle amount loaned to you) for the first period of the loan. During the second part of the loan, you pay both the interest and the principal payments, which are now larger than they would have been with a fixed loan, because you've been putting them off during the interest-only years.
Interest-only loans cost you less per month because, instead of paying down the principal you have borrowed and the interest due on that principal, you only pay the interest. This low cost to you is only present during the first portion of the loan, however. During the second portion of the loan, your monthly payment goes up dramatically.
Interest-only loans are not advisable for most people because they do not allow you to build up equity in your home, which is one of the main financial benefits of homeownership. Another downside to these loans is that homeowners use the low monthly payments these products offer during the first part of the loan period to purchase homes that are more expensive than they can actually afford. When the second part of the loan period comes along, they are likely to not be able to afford the increased monthly payment.
Some people actually are good candidates for interest-only loans. These are people who receive commissions or bonuses or who (with good reason) expect a dramatic increase in their personal incomes in the near future (such as medical students). Otherwise, these loans encourage the financial equivalent of gluttony and are not so good for you.
If you do take out an interest-only loan, you should know that you do have the option of making a higher-than-required payment each month, the excess of which will be applied to the loan principal. Over time, this practice will slowly reduce the principal you owe interest on. If you do this regularly every month, the loan will start to behave like a more conventional variable rate loan. It requires tremendous discipline, persistence and extra cash to make an interest-only loan work out well in the long run, however.
Balloon loans are another mortgage product that allows homeowners to buy a more expensive home then they could otherwise afford. These loans can be thought of as fixed loans with a 30 amortization schedule but only a 5 to 7 year term. This means that you make payments as though the loan was designed to pay off the underlying debt in 30 years but the term of the loan is only 5 to 7 years in duration. At the end of the 5 to 7 years you must pay off this loan in full. The last payment you make is for the balance of the entire loan. The final payment is typically huge in size, which is why it is called a balloon.
Most people who have balloon loans will cope with the very large final payment by going back to the bank for another mortgage with which they will pay off their first loan. The interest rates on the new loan may be dramatically higher, depending on economic conditions, however. Banks like these loans again because they are only betting on interest rates for a short period of time (5 to 7 years). As a result, the banks will typically assign a lower interest rate to this loan than they will to a 30 year loan. Homeowners thus get a lower initial rate but risk the potential of a higher rate in 5 years when they have to go back into the market again.
As with an interest-only loan, there is a very small group of people for whom this loan type makes sense. Balloon loans are best for people who know they will receive large commissions, bonuses or inheritances in the future, or who expect with good reason for their incomes to go up geometrically in the near future.