What are Interest-only loans and mortgages?

Interest only loan

An interest only loan is a loan where the borrower only pays the interest on the capital for a set amount of time. The capital will remain owing, and at the end of the term the borrower can repay the capital, convert the loan to a principal and interest payment loan, or renew the interest-only mortgage. In Canada some interest only mortgages let the borrower pay principal and interest, interest only, or principal and interest plus 20 percent. In the US, a 5 year or 10 year interest-only period is most common. This type of loan is beneficial if the borrow expect to get more money in the coming years – the early payments of the loan are quite a bit lower than later payments. The interest-only loan was popular in the 1920’s, but due to lack of work in the thirties and the Great Depression there were numerous foreclosures. Interest only loans are a popular method for borrowing money to buy an asset that will not depreciate too much, and can be sold at the end of the loan period – such as a house. In the UK, a popular way of buying a house was to combine an interest only loan with an endowment policy – thus it became an endowment mortgage. Endowment mortgages are not in use much anymore because of the negative impact of the stock market in the late 1990’s. In Canada, an interest only mortgage can work in combination with RRSP’s so that the holder gets a tax deduction, compound interest, and tax deferral. From an investor’s point of view, interest-only loans can be created artificially from structured securities such as CMO’s. A pot of securities, such as mortgages, is created and it is separated into tranches. Tranches are some of several types of security bonds offered as part of the same deal. Each bond is a slice of the deal’s risk – tranche is derived from the French word for slice. Cashflows that are received from underlying debts are spread throughout these tranches, which follow a set of regulations. An interest only loan is a type of tranche that can be created.

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