Interest Only Mortgages

Are Interest Only Mortgages the Answer to High Housing Prices?

As housing prices have soared in many parts of the country, potential home buyers have found themselves unable to afford the house they want.

An obvious answer to this dilemma is to look for less expensive houses, but this is sometimes impossible in certain areas of the country, especially the coasts.

But never fear, the lending community has come together to offer new ways of making housing more affordable.

One way is through an interest only mortgage. (Actually these were popular before the Great Depression, but fell out of favor due to the large amounts of foreclosures - a historical event that is now repeating itself.)

Interest only is really just the name of a repayment option. The mortgage itself is generally a conventional one. Interest only mortgages will generally carry slightly higher interest rates than a mortgage with normal amortization.

For example, if you wanted to borrow $300,000 at 5% using a 30 year conventional fixed mortgage, your monthly payment would be $1610, of which at the onset of the loan $1250 is interest and $360 is principal.

With an interest only loan, you would pay only $1250 a month for the first seven to ten years. You "save" about 22.5% on your mortgage payments.

All you have to do, at the end of the interest only period is: a) sell your house and move - and pray it's worth enough to cover the mortgage which is still $300,000; b) refinance at the going rate - and pray a bank will still lend you $300,000 on the house at whatever the rates will be 7 to 10 years from now; or c) repay the fully amortized amount, but this time amortized over 22 ½ to 20 years - $1852 to $1979 a month.

These loans are designed for people with a good, but not steady income: salesmen who work on commissions, business owners with seasonal income or someone whose major source of income are bonuses. The idea is that when they are flush they can pay down big chunks of principal.

Other people interested in this type of loan are those who expect big raises down the road or those who want to take the reduction in payments and invest the money for a higher return then they are paying in mortgage interest.

It really isn't a good choice for someone looking to buy more house then they can afford. A short term ARM might be a better option.

A short term ARM will likely carry lower interest rates and also ensures some reduction of the mortgage principal.

Given the strong growth of the US economy over the last few years, it could be that the odds are good that your house will appreciate in value and that your income will continue to grow and, hopefully, outpace inflation. In that scenario, an interest only mortgage is not that great a risk.

But don't forget trees don't grow to the sky. There have been and will again be declines in housing prices and a glut of houses on the market, at least in certain areas of the country. There are no guarantees your house will not depreciate or that you will be not be laid off and be forced into a lower paying job.

You can grow wealth two ways with a mortgaged home. One is by paying down the mortgage faster than required. With this method, there is no risk and your return is a tax free return equal to your mortgage rate - in this case 5%.

The other way is to take the $360 savings on your mortgage payments and invest it. If you make more than 5% after taxes, you are a winner. This doesn't sound too terribly difficult.

The long term growth of the stock market is around 10% a year. But it all depends on timing. From 2000 to late 2005, the stock market spent more time going down or sideways than up. If you had to cash out at the wrong time, you could have experienced a loss.

A no interest mortgage is a vehicle that you can consider, as long as you understand what you're getting into and are willing to face the risks inherent with this type of payment option.

It is highly unlikely that any but those with the very highest credit rating will be able to qualify for these mortgages since the subprime mortgage melt-down.]

2011 Update

For all those who bet the ever-rising housing market would bail them out, reality has sunk in - they lost their bet big time.

The only thing one can say is that you must keep your head when all others are losing theirs. Don't get sucked into conventional wisdom.

Not too long ago, that wisdom is that housing prices would continue to rise and any mis-judgements made in pricing or financing of the house could be covered by re-selling at a higher price.

The country is now littered with foreclosed houses - it might take 6 to 10 years to clear them all out.

Being conservative in your financial life may not be sexy, but it sure avoids lots of pain.