Interest Only, Except for the Risk

Okay, so what's wrong with interest-only mortgages?

At a time when house prices are soaring in many markets, "IO" loans, as they're often called, are becoming quite popular, and for obvious reasons. They offer lower initial payments that make it easier for buyers to qualify for their loans or that free cash for other purposes.

As the value of the house continues to rise, the buyer gains equity that can be cashed in by selling or refinancing a few years down the road. The loan gives the first-time buyer a boost on board the housing wealth train, so he doesn't languish in the rental station as the train speeds off without him. And it offers investors the ability to buy a second home or rental property and rack up big capital gains.

It sounds great, and thousands of buyers across the nation, and especially in hot markets like Washington, have signed onto IO loans for just those reasons. IO loans have constituted more than a third of the home mortgages in the Washington area this year -- and 54 percent of those in the District -- according to LoanPerformance, a housing data firm based in San Francisco.

But many newspapers, including this one, wet blankets that we are, have been suggesting that IOs may not be the greatest invention in financial history. Why? Because, while the wonderful things said about IOs may be true, the folks peddling these loans often leave a key factor out of the equation: risk.

In fact, IO loans are bringing to the housing market a risk factor that few home buyers have faced in the past, creating the potential for a whole class of owners who could, five or so years from now, find themselves unable either to make their mortgage payments or to sell their houses.

It's a peril that worries Federal Reserve Chairman Alan Greenspan. And if it worries him, it should worry you.

"The dramatic increase in the prevalence of interest-only loans" is a development "of particular concern," he told a congressional committee last week.

Historically in the United States, house purchases have been financed with long-term, fixed-rate mortgages. These loans allow buyers to lock in their mortgage cost on Day One, and they keep paying that same amount for decades. Market interest rates may soar, house prices may plunge, but the owner can simply hunker down, make the payments and live in the house.

These loans don't eliminate all risks, of course. Loss of income, or an untimely job transfer that forces an owner to sell, can result in losses or foreclosure. The risks are greater with conventional adjustable rate mortgages, which have become more common in recent years, but at least ARMs typically have caps on the amount the rate may rise, providing a shield against extreme situations such as the double-digit rates of the 1980s.

IOs, though, often have a kind of cliff that a borrower can run into (or fall off of, depending on how you like your metaphor). Their closest counterparts, "balloon" mortgages, in which the entire principal is due after a certain length of time, have never been very common in home sales.

While these loans can be structured many ways, a typical IO will require payments of interest only -- no principal -- for a period of years at the beginning, followed by a period in which the loan "amortizes," meaning that the borrower must begin making payments large enough to pay off the principal, along with interest, over the remaining term of the loan.