| An interest-only loan is a loan in which | | | | borrowing money to buy an asset that is |
| for a set term the borrower pays only | | | | unlikely to depreciate much and which |
| the interest on the principal balance, | | | | can be sold at the end of the loan to |
| with the principal balance unchanged. At | | | | repay the capital. For example, second |
| the end of the interest-only term the | | | | homes, or properties bought for letting |
| borrower may enter an interest-only | | | | to others. In the United Kingdom in the |
| mortgage, pay the principal, or (with | | | | 1980s and 1990s a popular way to buy a |
| some lenders) convert the loan to a | | | | house was to combine an interest-only |
| principal and interest payment (or | | | | loan with an endowment policy, the |
| amortized) loan at his/her option. | | | | combination being known as an endowment |
| US interest only mortgages | | | | mortgage. Since the poor stock market |
| In the United States, a five or ten year | | | | performance of the late 1990s, endowment |
| interest-only period is typical. After | | | | mortgages have become unpopular. |
| this time, the principal balance is | | | | Canadian interest only mortgages |
| amortized for the remaining term.[1] In | | | | Some interest-only mortgages in Canada |
| other words, if a borrower had a | | | | allow the borrower to pay interest-only, |
| thirty-year mortgage and the first ten | | | | principal and interest, or even |
| years were interest only, at the end of | | | | principal and interest plus 20% extra. |
| the first ten years, the principal | | | | An interest-only mortgage in Canada can |
| balance would be amortized for the | | | | be combined with corporate bonds in a |
| remaining period of twenty years. The | | | | Registered Retirement Savings Plan |
| practical result is that the early | | | | (RRSP) where the plan holder receives a |
| repayments (in the interest-only period) | | | | tax deduction, tax deferral, and |
| are substantially lower than the later | | | | compound interest. |
| repayments. This enables a borrower who | | | | From an investor's perspective |
| expects to increase their salary | | | | Interest-only loans are sometimes |
| substantially over the course of the | | | | generated articifially from structured |
| loan to borrow more than they would have | | | | securities, particularly CMOs. A pool of |
| otherwise been able to afford, or | | | | securities (typically mortgages) is |
| investors to generate cashflow when they | | | | created, and divided into tranches. The |
| might not otherwise be able to. During | | | | cashflows that are received from the |
| the interest-only years of the mortgage, | | | | underlying debts are spread through the |
| one is essentially renting the house | | | | tranches according to predefined rules, |
| since none of the principal loan | | | | an Interest-only (IO) loan is one type |
| decreases. The two great disadvantages | | | | of tranche that can be created, it is |
| are that in many states one has to pay | | | | generally created in tandem with a |
| property tax and purchase mandatory | | | | principal only (PO) tranche. These |
| property insurance.[2]. On the other | | | | tranches will cater to two particular |
| hand, the owner is still gathering | | | | type of investors, depending on whether |
| appreciation, even if they aren't paying | | | | the investors are trying to increase |
| down equity against their loan, and | | | | their current yield (which they can get |
| there are many other tax advantages to | | | | from an IO), or trying to reduce their |
| home ownership not available to renters. | | | | exposure to prepayments of the loans |
| In cases of aggressive appreciation | | | | (which they can get from a PO). |
| (e.g. "flipping" homes), a 100% | | | | Many homeowners saw the values of their |
| mortgage-to-value interest-only loan may | | | | homes increase by as much as 4 times its |
| also be able to be converted to a | | | | price in some markets in a 5 year span |
| conventional mortgage with a more | | | | in the early 2000s. Interest-only loans |
| favorable mortgage-to-value loan, | | | | helped homeowners afford more home and |
| resulting in an overall lower payment. | | | | earn more appreciation during this time |
| UK interest only mortgages | | | | period |
| Interest-only loans are popular ways of | | | | |