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July 2005

 

Is An Interest-Only Mortgage Right for You?

   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 the 1970s.

   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 incomes.

   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 years.

   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.

Copyright ©2005 Wisconsin Energy Cooperative News
All rights reserved. Reproduction in whole or in part without permission is prohibited.