Home Equity Loan
Interest-Only Loan
An interest-only loan is a loan in which for a set term the borrower
pays only the interest on the capital; the capital remains owing. At the end of
the term the borrower may renew the interest-only mortgage, repay the capital,
or (with some lenders) convert the loan to a principal and interest payment loan
at his option. It should be noted that some interest-only mortgages in Canada
allow the borrower to pay interest-only, principal and interest, or even
principal and interest plus 20% extra.
In the United States, a five or ten year interest-only period is typical. After
this time, the principal balance is amortized for the remaining term. In other
words, if a borrower had a thirty year mortgage and the first ten years were
interest only, at the end of the first ten years, the principal balance would be
amortized for the remaining period of twenty years. The practical result is that
the early repayments (in the interest-only period) are substantially lower than
the later repayments. This enables a borrower who expects to increase their
salary substantially over the course of the loan to borrow more than they would
have otherwise been able to afford. Interest only loans were popular in the
1920s. Due to the economic downturn and lack of work for the average person,
there were many foreclosures during the Great Depression of the 1930s.
Interest-only loans are popular ways of borrowing money to buy an asset that is
unlikely to depreciate much and which can be sold at the end of the loan to
repay the capital. For example, second homes, or properties bought for letting
to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a
house was to combine an interest-only loan with an investment in the stock
market, the combination being known as an endowment mortgage. The stock market
crash of the late 1990s showed this to be a gamble. An interest-only mortgage in
Canada can be combined with corporate bonds in a Registered Retirement Savings
Plan (RRSP) where the plan holder receives a tax deduction, tax deferral, and
compound interest.