Interest-only personal loans: How they work and what to watch out for

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. (Few 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 only the interest, the amount you owe never goes down.

Achieve Personal Loans doesn’t offer interest-only loans, but that doesn't mean interest-only loans 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.

What is an interest-only personal loan?

Interest-only loans allow you to make interest-only payments, usually for a set number of months or years. Once the interest-only period ends, you'll make payments toward the interest and the principal, which is the original amount of money you borrowed. 

An interest-only personal loan is rare, but it's possible to get an interest-only period with a personal line of credit or a home equity line of credit (HELOC). Some private student loans may also offer an interest-only period at the beginning of the loan repayment term. 

Interest-only loans can be attractive if you need or want a lower payment temporarily. The catch is that your principal balance won't go down while you make interest-only payments. And you'll have to be prepared to adjust your budget for much higher payments later on. 

How interest-only repayment structures work

When you get an interest-only loan, payments are split into two phases:

Phase I: Interest-only.  In the initial phase, you make interest-only payments. That means you pay only the interest fees on the amount you borrowed. This allows for a smaller monthly payment, but you won't make any progress paying down your balance.

Phase II: Full repayment. In the second phase, you start repaying the principal—while still paying interest. The amount will depend on how much you borrowed and the repayment term, but your monthly payment could easily double (or more). Some interest-only loans may also require a one-time balloon payment at the end of the term.

Interest-only loan example

Here's an example of how interest-only repayment works. Let's assume you have a $25,000 line of credit that has a five-year interest-only period, followed by a five-year repayment period. Your line of credit has a fixed rate of 12%. 

• During the interest-only period, you pay $250 per month, and your principal balance is unchanged.

• Once you enter repayment, your payment increases to $556, but your principal balance is paid off in five years.

This jump in payments is typical of any type of interest-only loan. Your loan amount, interest-only period, repayment period, and interest rate influence how large a payment increase you'll face. 

How interest-only loans compare to traditional personal loans

Interest-only loans differ from traditional personal loans primarily in how payments are structured. That structure, in turn, affects how your principal balance is reduced, the total cost of your loan, the level of predictability you have when budgeting for payments, and your overall borrowing risk. 

Let's compare interest-only loans to traditional personal loans, side by side. 

The biggest difference for many people will be the total cost since most loans calculate interest every month. With a regular installment loan, you pay down part of your principal each month. This means you pay a little bit less interest the next month and a bit more of your payment goes toward the principal. 

When you're only paying interest, your principal doesn't go down—so neither does the interest you pay. That interest-only period could be very costly if it stretches for years. This makes an interest-only loan typically much more expensive overall than a traditional installment loan.

There could also be differences in what's needed to qualify for an interest-only loan vs. a traditional loan depending on the lender. Learn how to get a personal loan so you can see what the process entails.

Pros and cons of interest-only personal loans

Interest-only personal loans have advantages and disadvantages. On the positive side, you may have lower payments initially, which can ease budget stress. However, you may find it difficult to keep up with higher payments later. Here's more on the pros and cons of interest-only loans. 

Pros: 

• Lower initial payments give your budget more flexibility at the beginning of the loan.

• Money that isn't spent on principal payments can be used to meet other financial needs. 

• Your lender might allow you to pay extra toward the principal without a penalty. 

Cons:

• You'll usually pay significantly more interest overall with an interest-only loan.

• Payment shock could set in if you're not prepared for the sharp increase in your monthly bill when the interest-only phase ends. 

• Balloon payment requirements could put you in a tight spot if you need to come up with a large sum of cash all at once. 

Additionally, interest-only loans may carry higher interest rates than traditional loans. That, along with any other loan fees the lender might charge, can make borrowing this way very expensive. 

Are interest-only loans a good idea?

There's nothing wrong with comparing all the options when you need to borrow, and interest-only loans may be on your radar if you're focused on low payments. An interest-only loan may be better suited for some needs than others, and it's smart to consider all your options.

An interest-only loan could make sense if you:

• Need lower payments temporarily

• Have reviewed your budget to make sure you can handle a higher payment later

• Can qualify for the lowest rates available, based on your credit and other factors

• Have some cash in savings to cover any balloon payments you might be expected to make

Interest-only loans could be a bad idea if you:

• Want to pay as little interest as possible over the life of your loan

• Won't be able to handle larger payments when the interest-only period ends

• Can get better rates or terms from a traditional loan

• Have irregular income that fluctuates month to month

• Lack savings to cover balloon payments

Only you know your exact financial situation, and whether you should get an interest-only loan is a personal decision. The reality is that these loans can be risky and expensive. You have to decide whether a temporarily lower payment is worth the extra cost and potential risk. 

Safer alternatives to interest-only loans

Interest-only loans aren't the only way to borrow, and you may prefer another path to get the money you need. Let's quickly look at some of the interest-only loan alternatives you might consider: 

• Standard personal loan. Most personal loans use amortization, which means your monthly payments are divided between the principal and interest over the loan term. A standard amortizing personal loan has the same monthly payment from start to finish, so there are no surprises. 

• Debt consolidation loan. A debt consolidation loan is most often a fixed-rate personal loan that you use to pay off high-interest credit cards and other debts. These loans offer predictable payments and a range of terms to fit any budget. 

• Creditor payment plans. Creditor payment plans are a structured way to pay, typically in monthly installments. For example, your doctor's office may let you enroll in a payment plan to cover medical bills without a loan. 

• Credit union loans. Credit unions can offer secured and unsecured loans at competitive fixed rates. You'll need to join a credit union to apply for a loan, but often being a local resident gives you eligibility. 

• Hardship programs. Hardship programs are designed to ease financial stress for people who may be unable to keep up with debt payments because of a job loss, illness, or another temporary situation. For example, credit card hardship programs may pause payments, lower your rates, and reduce or waive fees until you're back on your feet. 

If you think a standard personal loan could be the best option, get a rate quote for a personal loan through Achieve. It won't impact your credit at all, and you can get an idea of what you might qualify for in just a couple of minutes.