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Interest gains on interest-only loans

By Holden Lewis •

As mortgage rates rise and home prices zoom upward, some home buyers are turning to interest-only home loans.

An interest-only loan allows you to pay just the interest on the mortgage for a set period, often the first five, 10 or 15 years. You don't have to pay principal during that time. When the interest-only phase is up, the monthly payments skyrocket as you begin paying principal over the remaining term of the loan. Most borrowers expect to sell the house or refinance the loan before the interest-only period ends.

The main attraction of an interest-only mortgage is the lower monthly payment.

"It is becoming something that borrowers and Realtors are asking for, because it allows the borrower to afford more house," says Vijay Lala, senior vice president of product development for Countrywide Home Loans.

This is especially true in the last couple of months, as interest rates have risen steeply and home prices have gone nowhere but up. Some home shoppers have found to their chagrin that the houses they could afford in June are no longer affordable because of higher rates. Or rather, they found that their dream houses are no longer affordable with regular, fully amortizing loans. Enter interest-only mortgages, which increased in popularity after rates began rising at the end of June.

There had been steady demand for the loan type during the three-year refinancing boom that just ended, especially in places with pricey homes on the coasts. They also have been fashionable in parts of the South.

Two types of borrowers
Who gets the loans?

"It's really borrowers looking to either leverage their cash and borrowers who want the lowest payments they can get," Lala says.

For that second group, interest-only mortgages are the home equivalent to auto leasing, sort of. Both are handy ways to get something that you otherwise couldn't afford -- a bungalow in Malibu Beach, a BMW Z4.

The first group that Lala mentions consists largely of wealthier people with complex financial lives. They use interest-only home loans to free the cash that otherwise would go toward principal, and invest that cash where it presumably can bring a better return.

They have the option of paying more than the minimum amount every month and applying that money toward principal. If they don't pay extra, they don't contribute toward their home's equity. They still build equity, though, if the value increases and they eventually sell the house for more than they paid for it.

Have a plan
Lenders offer all sorts of interest-only programs.

If you are determined to get one, it might be best to go through a mortgage broker, who can search for the appropriate loan offering among various lenders. Countrywide offers interest-only periods of 10 or 15 years with fixed-rate and adjustable-rate loans. Another interest-only player, Wells Fargo, limits its interest-only offerings to adjustable-rate mortgages. They have five-year interest-only periods.

Joe Rogers, a national sales manager for Wells Fargo Home Mortgage, says interest-only loans are fine financial tools. But like all tools, they work best when they are used for their intended purpose. That means they should be part of a well-thought-out financial plan.

The best candidate for an interest-only loan is someone who could afford to pay for the home with a fixed-rate, 30-year mortgage, but who chooses an interest-only loan for sound reasons as part of a financial plan, Rogers says. Such a borrower isn't getting an interest-only loan just to squeeze into a house that is otherwise unaffordable.

If a borrower doesn't sell the home or refinance the loan before the interest-only period ends, the monthly minimum payment rises abruptly. Let's say someone borrows $200,000 at a fixed rate of 6.5 percent, paying only interest in the first five years. During those five years, the payments would be $1,083 a month, plus taxes and insurance, with nothing contributed toward the home's equity. At the beginning of the sixth year, the monthly payment -- principal and interest -- would rise to $1,350 in order to pay off the loan over the next 25 years.

By comparison, someone borrowing the same amount at the same rate, but paying principal and interest the entire time, would have monthly payments of $1,264. After five years, the borrower would have accumulated almost $13,000 of equity.

If you get an interest-only loan, you always have the option of making more than the minimum payment and having it applied toward principal. This feature appeals to people who make a good living, but don't have a steady income from month to month: small-business owners, salespeople who work on commission, employees whose end-of-year bonuses make up much of their annual incomes.

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