The Hidden Dangers of the Interest Only Mortgage

It is certainly no secret that the prices of homes have been going through the roof, and the prices of homes have quickly outstripped the ability of many buyers to find a mortgage they can afford.

This imbalance between incomes and home prices has led many lenders to invent increasingly creative ways to allow home buyers to qualify for more home than they would have in past years. One of the most creative of these new mortgage vehicles is the so-called interest only mortgage.

The number of interest only mortgage has skyrocketed over the last couple of years. In the year 2001, interest only mortgages made up a scant 1.6% of residential mortgages in the United States, but by the year 2004 that figure had ballooned to a full 31% of all mortgages. In the hot housing market of California, interest only mortgages now make up over half of all new mortgage loans, and that fact has many finance experts nervous.

The ads for interest only mortgage are certainly enticing, and just about every internet user or radio listener has seen or heard these ads touting large mortgages and small monthly payments. If you are in the market for a new home, chances are you have been offered such a mortgage, and you may be wondering if an interest only mortgage is right for you.

Those lenders and developers who push interest only mortgage loans often point out the fact that these loans allow buyers to purchase a higher priced home with a higher payment (at least for the first couple of years of the mortgage). However, experts in personal finance warn borrowers that there are some very real dangers of interest only mortgages, and such loans are inappropriate for many home buyers. It is important for any potential borrower to understand what interest only mortgage are, and the dangers they can present.

Interest only mortgage loans allow borrowers to pay only the interest portion of their mortgage loan for a specific amount of time, most often five to ten years. During this interest only period, the monthly mortgage payment contains no principal payment at all, and therefore no equity is being built during the interest only period of the loan.

The primary danger of the interest only mortgage loan comes at the end of the initial interest only mortgage period. After this initial period has expired, the interest only mortgage converts to a fully amortized loan, and when this happens the required monthly mortgage payment rises dramatically.

In addition, during the initial interest only period of the mortgage no equity is being built up through principal payments, and the only equity comes from appreciation in the value of the home. If the value of the home stagnates or falls, even by a small percentage, the borrower could end up owing more than the home is worth.

Interest only mortgages are available in both fixed rate and adjustable rate varieties, but most interest only mortgages are of the adjustable rate variety. This interest rate risk presents another potential pitfall to holders of interest only mortgages, and another reason to proceed cautiously when considering such a financing deal.

An adjustable rate shifts the risk of rising interest rates from the lender to the borrower, and while an adjustable rate mortgage can be great when interest rates are falling it can be quite dangerous when interest rates rise.

This interest rate risk is exacerbated even more when dealing with an interest only mortgage. Holders of interest only mortgages run the double risk of having the interest rate adjust upward, perhaps dramatically, just as the loan shifts to a fully amortized one. This higher interest rate can further inflate the required monthly payment, and make a once affordable home mortgage loan difficult if not impossible to deal with.

Perhaps the greatest danger associated with the interest only mortgage is the temptation of home buyers to borrow more than they can afford to pay back. Choosing an interest only mortgage based on that low initial payment can set you up for real financial difficulty down the road. It is better to borrow a little less, and buy a less expensive home, than to put the home you have worked so hard to buy at risk through borrowing too much.

Those considering an interest only mortgage would do well to pay attention to what the monthly payment will be after the interest only period has expired, and to borrow based on that number instead of the artificially low initial payment.

It is also important to remember that during the interest only period the only equity built up in the home will be through appreciation in its value. While it is certainly true that home appreciation has been very strong, this trend will reverse at some point. If you hold an interest only mortgage, you run the very real risk of having home prices fall just as your monthly mortgage payment is rising substantially.

Many home buyers will choose an interest only mortgage with the belief that they can sell or refinance the home before the interest only period has expired. While this can be a winning strategy in a low interest rate, rising home price environment, reality is unlikely to cooperate, and this perfect environment may not be available when you need it.

The aggressive marketing of interest only mortgages by many lenders represents another potential pitfall for borrowers. In many markets, interest only mortgage are being aggressively marketed to virtually every borrower, but personal finance consultants point out that these special mortgages are suitable in only a limited number of circumstances and to a very select set of home buyers. In most cases, buyers would be better off with a traditional mortgage, in which equity is built up beginning with the first monthly mortgage payment.

Some of the limited circumstances under which an interest only mortgage may be a good idea include:

Other than these very limited circumstances, in most cases an interest only mortgage represents an unacceptable risk. If you must consider such a mortgage, it is vital to proceed very cautiously, and to make every effort to pay down the mortgage as quickly as possible.