The Principal Facts of an Interest-Only Mortgage

by: Tanu Javeri

You are buying the house of your dreams with an interest-only mortgage. You'll get a low mortgage payment, and you'll maximize your tax deduction, all on your current income! Everything seems to be going good. But have you really understood the concept of interest-only mortgage and how it functions.

So What Is An Interest-Only Mortgage?

An interest-only mortgage might be a good fit for:

• someone whose income is mostly in the form of infrequent commissions or bonuses;
• someone who expects to earn a lot more in a few years;
• someone who truly will invest the savings on the difference between an interest-only mortgage and an amortizing mortgage, and who is confident that the investments will make money.

Again, an interest only mortgage is not the right choice for everyone, but it can be a very effective choice for some individuals.

The Deception You should Watch Out For

By remembering one critical fact the borrowers can save themselves against most deceptions. If two mortgages are identical except that only one has an interest-only option, lenders view that one as riskier. The reason is that, after any period has elapsed, the loan with the IO option will have a larger balance.

Deception 1:

An interest-only loan carries a lower interest rate. Lenders usually charge a higher rate for an identical loan with an interest-only option. Most interest-only loans are adjustable rate mortgages (ARMs), and ARMs have lower rates than fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates than FRMs because they are ARMs, not because they are IO.

Deception 2:

An interest-only loan allows the borrower to avoid paying for mortgage insurance. Any IO loans with down payments less than 20% that don’t carry mortgage insurance from a mortgage insurance company are being insured by the lender. The borrower is paying the premium in the interest rate rather than as an insurance premium.

Pitfalls of Interest-Only Mortgages - Risks a borrower should take into consideration

Interest-only payment options began to be offered to the masses not as a way to leverage their money, but rather as a way to borrow more money while not increasing the monthly payment. In turn they are using this method to be the high bidder, or to buy a somewhat larger home. Borrowers employing this method aren't "cash-flow" or "income-leveraging" borrowers. What they're doing is buying more debt.

One always has to remember that with increased leverage comes increased risk. And if you are a sophisticated investor, you should take into that as a borrowers who "debt leverage" into a more expensive home, with a larger mortgage, you are expecting that your income and the home both will appreciate. That may not be a big gamble when homes are appreciating, but it could certainly play differently in a down real estate market.

There is a danger in not reducing the balance. If prices should fail to increase during the interest-only period, and if you should find a need to sell the home, you could potentially be on the hook for thousands of dollars in sales costs which would need to be paid out of whatever equity (in the form of the down payment) you started out with.

Let's look at the more extreme side, prices actually decline during the mortgage holding period. If you finds yourselves in that situation, coupled with a low down payment, you could easily going "underwater" -- a descriptive term that means you are selling the property for less than the remaining balance of the mortgage.

Not only is house selling for less, the borrowers – that is you – would be required to somehow coming up with rest of the money to fulfill the mortgage balance as well as any sales charges (commissions, inspections, etc).

Interest Rate Risk

Unfortunately, most of the interest-only loans being made today feature only short fixed interest periods, if any; some features adjustable rates which can change each month. Thought the rates are low today, these low rates will inevitably rise.

The Final Analysis

Interest-only payments do have a place in the world, at least with the practical users. There are borrowers who can utilize a mortgage with interest-only payments to their fullest. However, it would require careful financial planning on behalf of the borrower to avoid going underwater.

Don’t rule out interest-only mortgages. Consider its pro and cons to your particular situation and the lender you would be working with. On the hind side also remember to question yourself that interest-only payments may be working for friends or family but does it work for you?