The Risks of Interest-only Mortgages

I'm no fan of interest-only mortgages. I think they are misused in most cases by people who have no business buying a home as large as they are buying. They stretch to the breaking point, using these mortgages to get their "dream home", and then when a financial emergency arises (which it always seems to do), they are in deep trouble.

Here's an article from Money where a person writes in and asks:

Dear Armchair Millionaire: I'm getting ready to buy my first home and I'm thinking about getting an interest-only mortgage to make it more affordable. What do you think of these types of mortgages?

First, he describes what interest-only mortgages are (in case we didn't know):

An interest-only mortgage is one that gives you the option of making only interest payments on your loan for a certain period of time, typically five to seven years.

After this period, it converts into a regular amortized loan for the remaining life of the mortgage. This means your monthly payment will jump, because you will now be paying interest plus principal over a shortened period of time -- just 20 to 23 years, as opposed to the standard 30 years of many mortgages. Alternatively, you can refinance at this time.

Next, he covers the benefits of interest-only mortgages:

Interest-only mortgages are booming in popularity for one good reason: They lower your initial monthly payments. Not only does this save you some money in the first years of the mortgage, it can enable you to get a larger mortgage (and more expensive house) than you'd otherwise qualify for.

For example, a traditional 30-year, fixed rate mortgage for $300,000 with a 5.875 percent interest rate would mean a monthly payment of $1,774 per month. On the other hand, an interest-only, adjustable-rate mortgage at 5.5 percent would mean a monthly payment of just $1,375.

But then he gets to the "real" answer -- for most people, they aren't a good idea:

As tempting as those lower initial payments may be, proceed very cautiously here. Despite their popularity, I believe that relatively few people are actually good candidates for interest-only mortgages. My guidelines will help you decide if it makes sense for you.

When interest-only mortgages don't make sense:

When it's the only way you can afford the house. With rapidly escalating home prices in many parts of the country, many people are finding that they only way they can afford their dream house is with an interest-only mortgage.

This route is risky. Your monthly payments will take a big leap after a few years -- bad news if you're struggling to make the payments now. While you could sell the house before you're required to begin paying principal, there's no guarantee that we'll still be in a hot housing market then.

When interest-only mortgages might make sense:

When you're planning to only stay a short time. Some people are certain that they'll live in the home just for several years and want to leverage interest-only mortgages to capture the biggest potential gain in equity they can. Again, however, the housing market is a big wildcard -- if prices drop, you could owe more than the home is worth when you want to sell.

When you have an irregular income. Interest-only mortgages can make sense for some people with irregular incomes (for example, people who work on commission). They can pay the lower interest-only payments when times are lean, and then make extra payments toward principal when they are flush. However, they have to have the discipline to put that extra money against the mortgage, and not a Caribbean vacation.

When you're sure your income will grow. If you are absolutely sure that your income will increase enough to cover the larger payments by the time the interest-only period is over, these mortgages can make sense. Most people just don't have that kind of surety in life, however.

Then he wraps it all up for us:

THE BOTTOM LINE: Interest-only mortgages make sense only some of the time. If you get one when it's not right for you, you're running unnecessary risks with your biggest investment.

I would have been a bit more anti-interest-only mortgages in this piece if I were him, but overall I can agree with the advice given here.

Comments

[monty loree]

Interest only mortgages are nasty.

I would say they're only good if that's the only way you can get a house.

You're not going to build equity in the property for years. So you need to be prepared to live in that property for 30+ years to enjoy any equity.