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.