How does an interest-only loan work?

Dear Yahoo!:

How does an interest-only loan work?

Nancy

San Carlos, California

Dear Nancy:

Most loan payments include both principal and interest. Interest is the price paid for borrowing money, while the principal is the actual amount of borrowed money. In an interest-only loan, the interest of the loan is paid off before the principal.

Many mortgages are interest-only loans -- this allows the lender to make a quicker profit on the loan, and keep the interest rate low. As James Kitchen notes in ArticleInsider, during the first years of an interest-only mortgage, the entire monthly payment goes toward interest.

Wikipedia also mentions that many interest-only loans are structured so the initial interest-only payments are lower than the principal payments. This allows the borrower, who expects to earn more over time, to obtain a larger loan. For more on the ins and outs of loans, we suggest visiting Yahoo! Finance's Loan Basics.