Mellody Hobson: Interest-Only Mortgages

What is an interest-only mortgage?

With an interest-only mortgage, monthly payments are lower because the borrower is only paying off interest, not principal during the early years of the loan.

      The borrower can make lower monthly payments for a substantial period of time -- usually five to seven years (can be anywhere from three to 10 years).

      Interest-only loans can come in different forms. Usually they are attached to an adjustable-rate mortgage, which means the mortgage starts with a lower introductory rate which expires and eventually ties to the prevailing interest rate.

      The real appeal comes from the savings in monthly payments. The savings can be significant, making interest-only mortgages particularly attractive to some people.

For example, according to The Boston Globe, the median home mortgage in the Greater Boston area is around $350,000. Under a traditional 30-year fixed-rate mortgage, a homeowner pays almost $1,800 each month. With the same mortgage under an interest-only arrangement, a homebuyer can expect a monthly mortgage payment of roughly $1,350. That translates into an annual savings of $5,400. Multiply this by five or seven years and people don't want to pass this deal up.

      This can be risky business because once the lower payment period elapses, monthly payments can balloon. First, principal gets added back in. Second, if the interest-only loan is part of an adjustable rate mortgage, the new interest rate can jump significantly and there will be a dramatic increase in your monthly payment.

Why are they appealing?

These loans are appealing for a number of reasons:

      First, the price of real estate has skyrocketed, making home ownership virtually unaffordable for many. According to the National Association of Realtors, housing prices were up approximately 11 percent nationwide last year and are expected to climb another 5 percent this year.

      According to the U.S. Census Bureau, between 2000 and 2003, the values of homes in Massachusetts rose 50 percent, and in California the increase was 46 percent.

People are stretching just to get a home. According to The Wall Street Journal, in California, only 18 percent of households can afford to buy a median-priced house using a conventional 30-year, fixed-rate mortgage. Creative financing makes homeownership a real possibility. Interest-only loans accounted for 61 percent of the mortgages taken out in the state to buy homes in the first two months of the year, up from 2 percent in 2002.

Interest-only loans also make it easier to get a lot more house for your money.

      Lower monthly payments help cash strapped consumers. Because payments are lower (initially and here's the catch), it feels like you are saving money -- which of course, you are not, because it will be due at a later date.

      The greatest advantage of this type of mortgage is that during the interest-only payment period, the entire monthly payment can be deducted on your tax bill as interest payments are tax-deductible (principal is not).

What are the risks?

My rule of thumb is that when things seem too good to be true, they usually are. Although there are benefits to this type of financing, especially if the money saved is invested wisely, the downsides can be far greater than the potential upsides.

      Homeowners can experience sticker shock when payments escalate and higher payments under this arrangement are almost a guarantee.

      First, most interest-only mortgages do not have a fixed rate conversion option, meaning when the interest-only period expires, the interest on your loan becomes adjustable (it adjusts on an annual basis for the remaining life of your loan) -- potentially at much higher rates than today.

      Second, if the value of your home declines, you will need to make up the difference when you sell your home.

      Third, paying only the interest on a mortgage does not allow you to build any equity in your home -- meaning home "ownership" is more like home "leasing."

Mellody's quick home tips:

      Interest-only loans are most suitable for people who only plan to stay in their home for a few years. However, while an interest-only loan allows a buyer to qualify for a larger mortgage and a more expensive home, biting off more than you can chew is rarely a wise financial decision.

      Interest rates are on the rise, making refinancing less and less likely to be an option down the road. So it is important to plan how you can pay for bigger monthly payments.

      Again, keep in mind the interest-only portion fluctuates with the prime rate and is very sensitive to rate increases. It is important, if you choose this route of financing, to pay down the principal along the way as well. Also, many interest-only mortgages come with a pre-payment penalty. So, if you decide to chip away at the principal with this type of loan, beware that you may face additional charges -- often up to 2 percent of the principal.

      Keep in mind the overall costs of home ownership. When buying a home, you need to think about more than just your monthly mortgage payment to figure out how much you can truly afford. You also need to evaluate the costs of property taxes, utilities, homeowners insurance and repairs.

      Try homeownership on for size -- rent before you buy.

      If you are set on buying, do your homework. It is important to determine what comparable homes are renting for to ensure if you needed to rent your home/apartment, you could get enough to cover your mortgage. If you can rent it for less than the mortgage, your home is overpriced.

Comparing Mortgage Rates

      Despite rising interest rates, mortgage rates continue to defy gravity.

      Mortgage rates are not only low but often better than last year's levels.

      It was reported yesterday in MarketWatch that the U.S. fixed mortgage rates fell for the ninth time in 10 weeks for the week ending Thursday.

      And based on research by Freddie Mac, the national average for the 30-year fixed-rate mortgage was 5.63 percent, well below last year's estimate of 6.28 percent.

      The 15-year fixed rate was also down to 5.20 percent, a slight decrease from last year's figure of 5.63 percent.

      Rates on one-year ARMS inched up since last week from 4.21 percent to 4.26 percent -- unlike the fixed rates, these were up from last year's comparison of 3.98 percent.

Mellody Hobson, president of Ariel Capital Management (arielmutualfunds.com) in Chicago, is Good Morning America's personal finance expert. Ariel associates Matthew Yale and Aimee Daley contributed to this report.