What is the primary risk of doing an interest-only loan?

The primary risk of doing an interest-only loan is that the borrower does not build equity during the interest-only period. In an interest-only loan, the borrower is only required to pay the interest on the principal balance for a set period, which often ranges from several years. During this initial phase, the borrower is not reducing the principal amount of the loan, meaning they are not building any equity in the property. This can pose a significant risk, particularly if property values decline, as the borrower may end up owing more than the property is worth once the loan converts to a traditional amortizing loan.

Understanding equity is crucial in real estate; it's the difference between the property's market value and what is owed on the mortgage. By not paying down the principal, the borrower misses out on potential financial benefits, such as increased equity that could lead to better refinancing options, improved financial stability, or easier access to future loans. Should property values decrease or remain stagnant, the lack of equity can also hinder the borrower's ability to sell the home or refinance the loan favorably.

The other considerations regarding prepayment penalties or changes in interest rates are relevant but do not address the core issue of equity accumulation inherent to interest-only loans. Thus, the correct answer underscores a