The Truth about Interest-Only Loans: The Good, The Bad and the Ugly
When home prices were rising, many homeowners, especially in high-cost regions like the Bay Area, chose interest-only mortgages as a way to increase their purchasing power. Those loans are now considered risky, but they still might be a sensible option for some consumers.
How It Works
An interest-only loan requires only that you pay only the interest portion of your mortgage. It permits, but does not require, principal payments during the initial period, typically three, five, seven or ten years.
After the initial period is over, you must begin repaying principal over the remaining life of the loan. For example, a 7/1 interest only loan means you may pay only interest for the first seven years, then principal and interest must be paid off during the remaining 23 years. The rate the 8th year, and therafter, is determined by adding the margin to the index (typically the LIBOR or treasury index).
By comparison, a traditional amortizing loan requires intererest and principal payments from day one, with more of the monthly payment going to interest in the early years and more to principal in later years.
The interest-only loan can lower your monthly payment by 20 to 25 percent by skipping principal payments in the early years, but you must be prepared for a big jump in payments when the interest-only period ends. Unfortunately, many people who took out interest-only loans didn't understand the risks, and are facing serious problems now.
How They Became Popular
When first introduced, interest-only loans were marketed to sophisticated homeowners who wanted to borrow as much as they could – to take advantage of the interest write-off – and to divert what they would have paid in principal into potentially higher-yielding investments.
Later, interest-only loans became a popular way of lowering monthly payments, giving consumers the ultimate flexibility in payments and increasing affordability. They were heavily marketed by salespeople who either didn't understand or didn't want to understand how they really worked, and rarely explained the potential downside of these risky loans.
In August 2007 the "affordability advantage" disappeared: lenders stopped qualifying borrowers based on the interest-only payment. An interest-only loan may still be the right choice for you, but only if you truly understand both the benefits and the risks.
Example: Suppose you borrow $500,000. If you chose a traditional 5/1 ARM at 6.25%, your payment would be $3,079 for the next five years. If you chose an interest-only 5/1 ARM instead, at the same 6.25%, your payment would be only $2,604 for the next five years. That’s a savings of $475 per month.
Now fast forward to five years later. Assume rates have gone up, and your traditional ARM rate goes up to 7.75% (index plus margin). Your new monthly payment would be $3,520 (that’s 7.75% on your balance of $466,038 over 25 years). Your interest-only ARM would also go up to 7.75%. Assuming you never paid any principal on the interest-only loan, your payment would go up to $3,776. That’s a huge jump from your initial payments of $2,500 – over $1,200 per month, compared to a $444 jump on the amortizing loan.
Of course, you saved a lot of money in the first five years with the interest-only loan, and if you tucked it away into a retirement plan or college savings, you would be pleased, especially if your home’s value has gone up as well over those five years.
