There is a particular type of loan that was extremely popular with American consumers two decades ago. It is known as the interest-only loan. If you are not familiar with it, you’re not alone. Most consumers have never heard of interest-only loans because they aren’t as popular as they once were.
The loans are still available under certain circumstances. For instance, real estate investors usually structure hard money loans to grow their portfolios as interest-only loans. But the loans are virtually unheard of in retail banking.
Interest-Only Loans: The Basics
An interest-only loan is so named because of the structure of its monthly payments. With each payment, the total amount submitted covers the interest on the loan. No money is put toward principal. So when is the principal paid? With the final installment.
Interest-only loans are sometimes referred to as ‘balloon loans’ for this very reason. The last payment on the loan balloons in size because the borrower must pay the entire principal amount.
By contrast, the payments on a traditional loan are structured differently. Take your mortgage. The amount you pay monthly is divided between interest, principal, taxes, and insurance. The largest amount is typically dedicated to interest. As for taxes and insurance, they are covered through an escrow account. The money from your payment is deposited into that account and ultimately used to pay your tax and insurance bills.
Lower Monthly Payments Are Attractive
Lower monthly payments are the most attractive selling point of interest-only loans. Consider a real estate investor who applies for a hard money loan from Salt Lake City’s Actium Lending. Being able to pay just the interest allows the investor to get away with lower monthly payments. The cash he saves month-to-month can be used for other purposes.
The obvious downside is that the investor needs to come up with the entire principal on the loan’s due date. Actium Partners and other hard money lenders account for that by requiring borrowers to present an exit plan with their loan applications.
Securing traditional financing is an exit plan Actium sees quite frequently. A borrower uses an Actium hard money loan to quickly close on a lucrative property. Over the course of the next few months, he then arranges traditional financing to pay off the hard money loan.
Why Interest-Only Loans Aren’t So Popular Anymore
While interest-only loans are as popular as ever in the hard money sector, they are not so popular in the retail sector anymore. Today’s market just is not what we had 20 years ago.
Throughout the 1990s and early 2020s, interest-only mortgages were the hottest thing in real estate. They allowed people who otherwise could not afford to buy a home to get into the real estate market. Lenders probably shouldn’t have written loans to a lot of those borrowers, but they did. It was a hard lesson learned.
Half way through 2007, the real estate market began to falter. Homeowners who had borrowed too much money found themselves underwater. That led to a crisis in confidence and a subsequent financial crash that led to what is now known as the Great Recession. Unfortunately, the almost unlimited availability of interest-only mortgages in the years leading up to the crash was partly responsible.
Banking reforms have since made interest-only loans unattractive for both banks and consumers. But because hard money lenders are not retail banks, they operate under a different set of rules. They can still write interest-only loans with minimal risk. And their borrowers, mainly real estate investors, like the advantages they get with interest-only loans.
