Interest-Only Loans: Why They're Dangerous Borrowing Options

You may have heard of a number of different types of credit vehicles designed to lower your payments or provide quick access to money for emergency purposes. One of the most common ways to appeal to borrowers in a tight spot is to offer an interest-only loan. This loan often looks great on the outside, with lower payments that look affordable.

But is an interest-only loan a good idea? How does it work? And what dangers does it bring? Here are a few answers to your questions. 

What Are Interest-Only Loans? 

An interest-only loan is, as its name implies, a loan where you are only required to pay the interest each month — usually for a specified period of time. So, if you borrow $5,000 on a one-year loan at 5% interest, the interest portion of that loan may be as low as $20 per month.

You would then choose separately how you want to pay off the principal, which is the amount you actually borrowed. The terms of each interest-only loan will specify what those options are. 

What Are the Drawbacks to Interest-Only Loans?

A low monthly payment sounds like a perk of this loan, but it's actually very dangerous. The reason? You are only paying the added interest each month without paying anything toward the principal, which is the amount you actually borrowed. So, in the example above, after paying that $20 monthly for a year, you would still owe $5,000 — which would now be immediately due. 

Generally, interest-only debts come with two basic options for paying back that principal.

First Option

The first option is to save up the money on your own and pay it in full when the loan's term is up. However, most interest-only loans have terms from 1–4 months. This results in a payoff oftentimes much higher than the borrower’s paycheck. Most borrowers can't see their way out of this situation.

Also, most borrowers don't find themselves with access to the cash needed to pay back their loan all at once. This requires having excess money at the end of each month and a way to set it aside for a balloon payment — an ability that many Americans simply don't have.

Because the borrower can't pay off the loan, they must often resort to a second option.

Second Option

This second option is to take out another loan and use it to pay off the first. Unfortunately, interest charges start over again, and the cycle continues. The original principal may not be paid off for months or years. And in the meantime, you've paid hundreds or thousands in interest without seeing a result for your efforts.

What Are Some Better Solutions? 

Does an interest-only loan sound like it might be a bad idea in your situation? The good news is that you have other options. If you need to save money on a monthly payment, you’d do better to focus on finding an amortized loan with a lower interest rate.

An amortized loan is one that puts your monthly payment toward a combination of principal and interest. In this way, you ensure that some principal is paid each month. Finding a lower interest rate helps save money with the danger of paying only interest.

If you are considering an interest-only loan due to past credit issues, remember that you can still find good-quality amortized loans from lenders that specialize in helping those with damaged credit histories.

Ardmore Finance offers amortized, signature loans to help you avoid high-risk loan options. Want to learn more? Call today to speak with a loan specialist. We can help you find a better loan option that fits your needs and budget.