Is An Interest-Only Mortgage Right for
The United States is experiencing
a housing boom that is hard to deny. In April, sales of existing
homes rose 4.5 percent to a record 7.18 million annually. The
cost of a single-family home rose 15 percent during the past
year, and topped $200,000 for the first time. According to federal
government economists, this is the fastest growth pace since
Many of us are now being bombarded
with radio ads for interest-only mortgages. The ads sound convincing:
You pay only the interest and use what you would have paid in
principal for other things such as paying down higher-interest
credit card debt, taking a vacation, improving your home, or
buying a new car. The ads must be convincing because 17 percent
of the mortgages issued in the second half of 2004 were interest-only.
Pros and Cons
Interest-only mortgages can be
an advantage if you are buying real estate in a rising market
and you intend to sell the property quickly. They can also be
an advantage if you have the discipline to put away or invest
enough money to pay off the principal at a later date. But what
happens if the housing market begins to cool, as many experts
believe it will?
According to the federal government,
consumers are increasingly being stretched in the housing market.
For example, until the late 1990s, median house prices were
2.75 times median income. In 2004, the median ratio increased
to 3.4. In other words, housing prices are rising faster than
What can go wrong with an interest-only
mortgage? First, an interest-only mortgage may entice a consumer
to buy a home that is more than they can truly afford. This
is somewhat like the furniture ads you hear that scream, “No
payments until 2007!” Both sound good, but eventually
you have to pay for what you purchased, and beware if you have
a history of missed or late payments. The mortgage might allow
for accelerated principal payments.
Sooner Or Later…
Second, most interest-only mortgages
allow you to avoid making principal payments for the first term,
usually five to ten years. Then, your contract normally requires
you to begin paying principal. Of course, this means you will
make larger payments over the remaining 20–25 years than
if you made principal payments during the first five to ten
Third, if housing prices begin
to fall, homeowners with interest-only mortgages who then sell
their homes could find that they have to make substantial payments
at closing because the principal balance on their mortgages
is larger than the value of their houses.
Fourth, most interest-only mortgages
charge a higher monthly interest rate and, if the interest rate
is adjustable, your interest-rate risk could increase dramatically.
Finally, your home is often your
largest asset. If you haven’t made principal payments,
you will miss out on creating what will likely be your largest
source of equity. Yes, a mortgage that requires both interest
and principal payments may be more “painful” on
a monthly basis, but it’s an effective way of saving what
you may need to live on in your retirement.