July 2005

Interest-Only Mortgages — Are They a Good Deal?

Interest-only mortgages have become as hot as the booming housing market in some areas of the country. In the U.S. in 2001 interest-only mortgages made up 1.6% of residential mortgages; that figure ballooned to 31% of residential mortgages in 2004, according to a May report in Fortune Magazine. Maybe you've seen ads for interest-only mortgages? If you've been shopping for a new home, maybe an agent or developer has mentioned the possibility.

The popularity of interest-only mortgages has been rising steadily particularly in hot housing markets where home prices have been soaring. This type of mortgage isn't new—it's been around at least since the 1920s—but its availability to a wide range of buyers and its combination with adjustable-rate mortgages (ARMs) are recent developments. Boosters of interest-only mortgages tout their ability to offer more home for a lower payment (at least for the first few years). Most personal finance experts warn that interest-only mortgages come with very real dangers and aren't appropriate for most homebuyers. This report provides a brief overview of interest-only mortgages and profiles the potential pitfalls and pluses.

What is an interest-only mortgage?

An interest-only mortgage (IO) allows the borrower to pay only the interest on the mortgage for a specified period of time—typically 5 or 10 years. During this period, the monthly payment contains no principal. Because the borrower is paying only interest on the loan, the payment during this period is lower than it would be with a conventional fully-amortizing loan where the payment includes both principal and interest. At the end of the interest-only period, however, the IO loan becomes fully amortizing for the remainder of the loan term. At this point, the monthly payment amount also rises dramatically. During the IO term, the borrower can make payments on the principal but such payments aren't required. If no principal payments are made during the IO period, then the borrower builds equity in the house only if its value appreciates. If the value of the house falls, then the borrower could actually owe more than the house is worth.

Both fixed-rate and adjustable rate mortgages are available with interest-only options. Lenders offer a variety of interest-only mortgages, particularly with adjustable- rates.

Disadvantages and potential dangers of interest-only mortgages

The greatest potential danger of an interest-only mortgage is that it may tempt borrowers to buy more house than they can realistically afford. For example, one ad that we've seen says something like, "Skip that starter house. Get the home you've dreamed of. You deserve it." Choosing an IO because its payment is lower doesn't take into account these potential disadvantages and dangers.

• Payments will skyrocket at the end of the interest-only period. The payments at that time will be higher than payments would have been with a traditional mortgage.
• During the interest-only period you will build equity in your home only if the home's value increases. But remember that property values can decrease as well as increase. Increasingly real estate experts are warning that the rapid rise in home values in many markets may represent a "bubble" that is due to burst, at which time values will slow or even fall.
• If property values go down, you may owe more than the property is worth.
• An IO mortgage allows a borrower to purchase more house than they can really afford. Choosing an IO because you cannot afford the larger payment on a regular loan is a warning sign that you may be over extending. A recent Washington Post story reported that foreclosures on residential mortgages went up in 47 states in March 2005; a contributing factor may have been moderate-income families overextended in IO or ARM mortgages.
• You will usually pay a higher rate of interest for IO mortgages. Their rates are typically an eighth or quarter of a percentage point higher than rates on comparable interest-and-principal loans.
• Many homebuyers select an IO or IO/ARM because they plan to sell their home or refinance in a few years before the end of the IO period. Conventional mortgage rates are among the lowest ever right now, but many analysts believe that mortgage rates will rise over the next five to ten years; if that happens, the refinancing could cost you even more.

Potential for double trouble—interest-only and ARMs

Interest-only loans are risky. Many adjustable-rate mortgages (ARMs) have risks, too. Add the two together and you may increase your risk dramatically. For many interest-only ARMs, the initial interest rate applies for one year or less. With a typical interest-only period of 5 to 10 years, the ARM rate will adjust during the interest-only period. The surprise for many borrowers is that the new payment is calculated on the original loan amount (you haven't paid any principal), rather than the smaller loan balance on a principal-and-interest ARM. In one scenario, the ARM adjusts annually and each adjustment is the maximum annual percentage rate, typically 2%. By the fourth year, your ARM has jumped 6% (the lifetime maximum). If your starting interest rate was 5%, you are now paying interest-only on an 11% loan. In this scenario your payment has gone up under interest-only and will be even higher when the loan rolls over into its amortizing phase where you begin to pay both principal and interest.

Potential advantages of interest-only mortgages

Proponents of IO mortgages point out these potential advantages.

• Lower monthly payments than a traditional mortgage during the interest-only period
• More purchasing power
• The ability to invest the money that would have been used for paying down the principal. (Of course, this benefit does not apply if the borrowers have chosen an IO because they can't afford the conventional payment.)
• You can pay down principal when you choose

Who may benefit from an interest-only mortgage?

Interest-only mortgages are being marketed to everyone, but most personal finance experts point out that they are really most suitable in a few limited circumstances. Most individuals would be better off with a loan that pays down principal and builds equity. An interest-only mortgage might be suitable, however, if:

• A guaranteed part of your income comes in annual or semi-annual bonuses or commissions and you have an iron-clad promise with yourself to pay down principal when those bonuses/commissions arrive.
• Your employment contract or track realistically leads you to expect to earn a lot more money in a few years.
• You are already an experienced, successful investor and will actually invest the savings from an interest-only mortgage.

Remar's Recommendation: Smart homebuyers will shop for a home and a mortgage that best fits their needs and budget. I suggest that you check out the techniques and tips in our RealityCheck Home Buying Guide and RealityCheck Mortgage Guide before you begin home shopping or while you are in process. If you do your homework and consider all the factors, you can have a dream home and protect (not risk) your financial future. Your credit union can help-call on them.

For more information

Know the Real Price of New Mortgages from the Wall Street Journal's RealEstateJournal.com

Interest-only mortgage deja vu by Jack Guttentag on bankrate.com provides a good overview of the risks and misperceptions of interest-only mortgages.

 

Prepared for Elevations CU by Remar Sutton & Associates, July 2005. All rights reserved. Reviewed October 2007.

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