Interest-Only: Borrower Beware

Lenders say such loans make sense for some people, including those whose homes have risen in value so much that they are sheltered even if prices fall, people with high but irregular incomes, such as commissioned salespeople; and people who face a sharp temporary cash squeeze.

A traditional loan, with a fixed rate for 30 years, would cost $1,847 per month for a $300,000 loan at 6.25 percent. The interest rate stays the same for the life of the loan, and each monthly payment is split between covering interest costs and the principal.

Payments on a $300,000 interest-only, adjustable-rate loan would be just $1,562 per month because none of the money in the early years is used to reduce the principal amount and the borrower, not the lender, is taking the risk that interest rates will rise. There are even more risky loans being offered, ones that start with rates as low 1 percent and quickly adjust -- the payment on a $300,000 loan of that variety could be just $965 a month at the start. Then, after a set term -- usually three, five or 10 years -- the borrower must begin paying the principal, which can double the monthly payment.

If the borrower cannot afford those higher payments, a vicious cycle could begin:

In many of these loans, because the borrower is not paying the full monthly interest expense, that shifts to the mortgage balance, meaning the balance owed goes up, not down, as it does in a conventional loan. This is called negative amortization.

Then, if home values fall, borrowers might not be able to sell their houses at a profit to get out from under the bigger mortgage payment. That would mean they could lose their homes to foreclosure.

If loans do go into foreclosure, banks could lose money. If too many loans go into foreclosure, banks could fail and be required to tap the federal insurance fund. If the insurance fund runs dry, taxpayers could ultimately be on the hook, as they were when many savings and loans failed in the 1980s and 1990s.

Some lenders say that interest-only loans meet a need and that if borrowers end up with problems, they have only themselves to blame.

"It's not the best way to buy a home, but for some people, it's the only way," said mortgage broker Christopher Cruise, who trains brokers for large lenders. He said some people fail to educate themselves before taking on what will be the single largest investment of their lives and then wail about the mistake they made.

"People spend more time researching the flat-screen TVs they buy than their home mortgages," he said.

But Jack Guttentag, a retired professor of finance at the University of Pennsylvania's Wharton School of Business, whose Web site, http://mtgprofessor.com/ , offers borrowers advice and information, said it is easy for buyers to be duped.

"There are a lot of hustlers in this market who induce people to take loans that are not in their long-term interest," he said.

Some people, however, say they are pleased with their interest-only loans. Archivist Suzanne Adamko, 32, refinanced her Beltsville townhouse in May with an interest-only loan that has a fixed rate for seven years -- and she intends to refinance to a fixed rate or move during that time. Although she is required to pay only the interest, she adds about $250 a month to the payment, which more than covers what she would pay toward principal with a standard loan. Her mortgage balance is declining while home prices are rising.

"I thought I wanted a 30-year fixed mortgage, but my financial adviser said, 'That's your father's mortgage,' " she recalled. "He said, 'You may not be in the house that long,' so I could take advantage of the other options open to me."

Clerman, however, said he wishes that he had never gotten the interest-only loan and that he hadn't been so "wowed" by the initial low rate. "There are some people out there getting crushed with these interest-only loans," he said.