Interest-only personal loan: Lower payments now, higher costs later

A personal loan could help you pay for life's big or small expenses. And we all want affordable monthly payments, so it makes sense to wonder about loans that have the smallest possible payments such as interest-only loans. (Not all personal loans are interest-only.) 

When your required payments are very low, it’s easier to fit them into your budget. But when you pay interest only, the amount you owe never goes down.

While Achieve does not offer interest-only loans, that doesn’t mean they couldn’t work for some borrowers in some situations. There’s no one-size-fits-all loan out there. Let’s explore how interest-only personal loans work and what alternatives might be available.

How interest-only loans work

For the most part, interest-only loans work like other loans. You borrow a lump sum of money and you pay it back, usually in monthly installments, with interest. 

The difference between an interest-only loan and other installment loans is how payments are structured. With a standard personal loan, your payments are split between two things:

• Principal, or the amount you borrow

• Interest, which is what you pay to borrow

With an interest-only loan, you make payments toward the interest alone for a set term. Once the interest-only period ends, you'll make regular monthly payments of principal and interest. 

Interest-only mortgages are often an option for people building a new home while still living in their current home. Interest-only payments on the new mortgage help keep the total housing cost more affordable during construction. The borrower would typically sell the current home (and get rid of that payment) once the new home is ready to move into.  

You could also get interest-only private student loans, which help keep payments affordable while you’re in school. 

While interest-only personal loans are less common, it's possible to find lenders that offer them. 

Pros and cons of interest-only personal loans

Personal loans let you borrow money for personal reasons. Some of the most common are: 

• Personal loan for debt consolidation

• Personal loan for home improvements or repairs

• Personal loan for large purchases

• Medical loans

• Emergency loans

Interest-only personal loans have advantages: 

Lower payments

Interest-only loans offer lower payments initially. You might appreciate that if you need some extra room in your budget temporarily.

Predictability with a fixed rate

Fixed rates could offer some predictability since your monthly payments stay the same if the interest rate doesn’t vary. It's also easier to estimate the total interest you'll pay on the loan. If you choose a variable-rate loan—meaning the rate could go up or down over time—you might initially get a lower rate.   

No collateral for an unsecured loan

Unsecured personal loans don't require collateral, which is another benefit. Collateral is something of value that serves as a financial safety net for the lender. If you don’t repay the loan, the lender could keep the collateral, and sell it to recover their losses. For example, when you get a mortgage, the home is the collateral.

Interest-only loans also have some notable downsides:

Potential higher overall cost

When you only pay the interest, the amount you owe doesn’t go down. If you borrow $50,000 and make interest-only payments for a year, after 12 months you'll still owe $50,000. That lack of progress against the balance could mean that the debt drags out longer than a similar loan that has regular principal and interest payments. The longer you hold onto a loan, the more interest you’ll eventually pay on what you owe. The way to minimize interest is to pay off the loan in less time.

Payment spike

Once the interest-only period ends, the payment amount goes way up. That’s because now you'll have to pay both interest and principal in an amount calculated to pay off the loan by the end of the repayment term.

Assessing the risks of an interest-only loan

The main risk of an interest-only loan is that you won't be able to afford the regular payments for the long term. 

A low monthly payment may be attractive, but you have to be sure that you'll still be able to pay if the payment increases once the interest-only period ends. The same goes for a variable-rate loan: You'll need to consider how a larger payment would fit in your budget if the rate increases.

Getting a secured interest-only loan, meaning you have collateral, could get you a lower rate. The drawback there, however, is that if you can't make your payments, you risk losing your collateral to the lender. 

Eligibility, application, and other considerations

What's required to get an interest-only personal loan? Lenders decide who qualifies, but typically, eligibility is based on:

• Credit scores

• Income

• Collateral, if you're interested in a secured interest-only loan

The minimum credit score to get a personal loan varies by lender. Some lenders might work with borrowers who have scores in the 640 range on the FICO® scale, while others may expect a score of 700 or better.

The higher your credit score, the lower your interest rate is likely to be. Aside from the minimum requirements to qualify, it also helps to consider:

• Minimum and maximum loan amounts

• Repayment terms

• Length of the interest-only period

• Fixed vs. variable-rate options

• Special extras or benefits, such as an autopay rate discount

Once you find an interest-only loan, you can usually apply for it online. The lender should tell you what you need to provide to complete the application. 

At a minimum, you'll need some basic information like your name, address, date of birth, and Social Security number. You may also need to share bank statements, pay stubs, or tax forms as proof of income or assets. 

If you're approved for an interest-only loan, you'll need to sign the loan paperwork and tell the lender where to send the money. Once it's in your bank account, you're free to use it however you like. The lender should also give you a full breakdown of how long the interest-only period lasts, what you'll pay monthly, and when payments are due. 

Use interest-only loans responsibly for home improvements

An interest-only home equity line of credit (HELOC) lets you borrow against your home's value. A HELOC is a mortgage, and all mortgages are secured loans. Your home is the collateral.

When you get a HELOC, you have a:

• Draw period, during which you can access your line of credit

• Repayment period, when you pay what you borrowed back

With an interest-only HELOC, you make interest-only payments during the draw period. You only pay interest on the part of your credit line you use. So if you qualify for a $100,000 HELOC but only use $50,000, you'd just pay interest on the lower amount. 

It might make sense to choose a HELOC in place of an interest-only personal loan if you want to use the money for home improvements or repairs. Here's why:

• You might qualify for a tax dedication for the interest you pay on a HELOC. (We’re not tax pros so you’d want to consult with a qualified tax professional about your specific situation.) 

• You might be able to borrow more money than you could with a personal loan. The loan amount depends on the lender’s limit and the amount of home equity you have. (Equity is the difference between what your home is worth and what you owe on it.)

• You might get more time to repay the loan compared to the repayment term on a personal loan. Taking more time to pay could mean a lower monthly payment. 

If you get a HELOC you need to be sure you can pay it back for one important reason. If you don't pay, you could lose your home. So that's another interest-only loan risk to weigh. 

Other borrowing options

Interest-only loans may work better for some borrowers than others. If you're unsure whether it's a good fit for you, you might consider these possibilities. 

• Credit card. Credit cards are convenient since you can charge purchases as needed and pay them off over time. Interest rates can be steep, but you can avoid interest if you pay in full each month. 

• Personal loan (not interest-only). Regular personal loans can offer competitive interest rates if you have good credit. You may want to check your credit score and shop around for rate quotes to find out what you qualify for. 

• Home equity loan. A home equity loan allows you to borrow a lump sum of money against your home's value. Your home is the collateral, and rates are usually fixed. 

With any loan you choose, it's a good idea to read the fine print carefully before you sign off. You don't want to find out after the fact that a loan has hidden fees or other terms that could affect your repayment.