What is a Standing Loan?
Standing loan refers to a type of interest-only loan in which the repayment of principal is expected at the end of the loan term.
How a Standing Loan Works
With a standing loan, the borrower is required to make only interest payments during the life of the loan. At the end of the loan’s term, the borrower must pay back the entire principal amount in a single lump sum. This way of structuring a loan involves increased risk for the lender because of the possibility that the borrower won't be able to come up with the money to make that final principal payment. For that reason, a standing loan generally charges a higher interest rate than a traditional amortized loan, such as a typical home mortgage.
Standing loans are relatively rare and tend to be used most often for home or automobile purchases. They are just one type of interest-only loan. More common interest-only loans include adjustable rate loans with a balloon payment at the end of an introductory period or a 30-year mortgage that is interest-only for the first 10 years.
[Important: An interest-free standing loan can reduce borrowers' monthly payments, but with the risk that they'll be unable to repay the principal when it comes due.]
Pros and Cons of a Standing Loan
From the borrower’s perspective, a standing loan can be a way to get into a home or buy a car that the borrower might not otherwise be able to afford. The monthly payments will be lower than on a loan that requires the regular repayment of principal.
If borrowers have reason to believe that they will be able to make that final principal payment, the standing loan structure allows them to invest that money somewhere else over the life of the loan. What's more, because the interest payments on home mortgages are generally tax deductible up to certain IRS limits, in the case of a standing mortgage the borrower’s entire payment could be tax deductible.
A standing loan can, however, be a risky proposition for borrowers. There are a number of caveats to keep in mind. For starters, standing loans are often offered with an adjustable interest rate. Adjustable rates may be attractive and seem affordable initially, but they can climb in the future and lead to higher monthly payments that may be out of reach. A standing loan may also encourage borrowers to buy more expensive homes or cars than they can really afford, especially if an unexpected financial crisis, such as a job loss, comes along.
Borrowers shouldn't agree to a standing loan unless they have strong reason to believe that they will be able to make the final principal payment. For that reason, borrowers are wise to make sure the money they are not paying out as principal each month is being put to good use. The temptation to spend those savings rather than set them aside for the future can get a borrower into trouble down the line.
Finally, a home purchased with a standing loan may not appreciate as quickly as the borrower expects. It might, in fact, lose value, as many homes did in the 2008-2009 financial crisis. That means the borrower could be unable to refinance the loan or recoup enough money from selling the home to make that final principal payment.