What type of loan exposes the lender to a substantial amount of principal risk?

Interest-only payment loans expose the lender to a substantial amount of principal risk because during the interest-only period, the borrower is not paying down the principal balance of the loan. This means that the outstanding loan amount remains unchanged, potentially leading to a situation where the borrower may owe more than the property is worth if property values decline.

This creates a higher risk for lenders because they do not receive any principal repayment during the interest-only phase and later may face difficulties if the borrower is unable to refinance or pay off the principal once the payment structure changes. As a result, if the borrower encounters financial difficulties or if the market shifts unfavorably, the lender stands to lose a significant portion of their principal investment.

The nature of the loan structure inherently involves greater risk regarding the lender's exposure to the overall investment, making interest-only loans more susceptible to principal risk compared to other types of loans such as fixed-rate, variable-rate, or subprime mortgages, where regular payments typically contribute to reducing the principal.