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