Interest-Only Borrowers Are Rolling the Dice
Q: I am a first-time home buyer with limited income. My mortgage lender has suggested I consider an interest-only loan. I have heard that these kind of loans are not necessarily in the best interest of consumers. Can you explain what an interest-only loan is and why it could be problematic?
A: An interest-only loan is exactly what it sounds like: The borrower pays only the interest for a period of time.
Let's take this simple example: You borrow $200,000 at 6 percent. If you amortize this over 30 years -- that is, pay down the principal over that time, as well as interest -- your monthly payment would be $1,199.11. (This includes just principal and interest, and not taxes or insurance.)
At the end of 30 years, you will have paid off the loan. Why? Because every month, a portion of your mortgage payment goes to reduce the then-outstanding principal balance of your loan. During the first seven years, the outstanding principal balance goes down very slowly. However, if you keep the loan for longer, eventually more of your payment will go toward reducing the principal and less to paying interest.
Now let's look at an interest-only loan in the same amount and at the same rate. The monthly payment is $1,000. No portion of this payment goes to reduce the original principal amount of $200,000.
In our 30-year amortization example, when you make the very first payment, $1,000 goes for interest and $199.11 will go toward principal, thereby reducing the balance down to $199,800.89. If you take 6 percent of this new balance and divide it by 12, the interest due on the new balance has been reduced to $999. This means that your next mortgage payment will lower the principal balance by $200.11 ($1,199.11 minus $999).
Computers obviously can do this math much quicker, so I will only show the example for the first two monthly payments. But as you can see, for every monthly mortgage payment you make, you are slowly reducing the amount you owe your lender.
Your mortgage broker is correct: In our example, if you take an interest-only loan, you will theoretically be saving almost $200 month on the mortgage payment. I purposely use the word "theoretically" because typically, interest rates on these interest-only loans will be one-eighth to one-quarter of a percent higher than the standard 30-year amortized mortgage.
Interest-only loans are not new, though they have become very popular in the past year. My research indicates that these types of loans originated in the 1920s. However, when our country went into an economic depression in the 1930s, many of the mortgages that were foreclosed upon were interest-only loans.
So lenders consider these loans a higher risk and thus charge a slightly higher interest rate to compensate.
There is yet another problem with these types of loans the way they are set up today. Typically, an interest-only loan is an adjustable-rate mortgage. That means that for a set period, often the first five years, you will pay only interest. Then, the interest rate will be adjusted to meet market conditions, meaning it could go higher. Additionally, the payment schedule will be reset so that you will pay off the loan at the end of a fixed period of time, such as 15, 25 or 30 years, the way you would with an amortized loan.
This means that when your interest-only payments stop, you will have to start making substantially higher monthly payments to catch up.