Who Should Take Interest-Only Mortgage Loans?


December 1, 2003

"You have been harshly critical of interest-only loans. Are you claiming that they serve no useful purpose for anyone?"

No, that is too sweeping a statement. My complaint has been directly primarily at the way interest-only (IO) loans have been marketed. Some prospective borrowers receive the impression that these loans carry lower interest rates or can be paid down more quickly than mortgages with fully-amortizing payments, or that the initial interest rate holds for the entire IO period. I don’t like to see decisions based on misperceptions.

IO loans meet some legitimate needs. But before explaining what these are, I want to take another look at the fully amortizing (FA) mortgage. I have belatedly come to realize that a major reason there are so many misperceptions about IO is that borrowers don’t fully understand the FA mortgage, which is what an IO mortgage is not.

Consider a 30-year fixed-rate loan of $100,000 at 6%. The FA payment is $599.56. This is the payment that, if maintained over the term of the loan, will pay it off completely, assuming the interest rate does not change. The $599.56 has two parts. The interest part is .06/12 times $100,000, or $500. The remaining $99.56 is amortization. It is applied to the balance, which falls to $99,900.44.

This $99.56 of amortization in month 1, and the gradually rising amounts in the months that follow, is the difference between the IO and the FA mortgage. The FA mortgage has a forced saving feature built into it. The borrower is required to save $99.56 in month 1, $100.05 in month 2, and progressively larger amounts in all succeeding months. With the same monthly outlay, the savings rise every month.

Since the borrower with a FA mortgage saves the 6% that he would have otherwise had to pay on the amounts amortized, he is in effect earning 6% on his savings. The yield is risk-free to the borrower. For the great majority, it is the best possible investment available anywhere.

When you take an IO mortgage, you pay only the $500 in interest, and forego the forced savings plan built into the FA mortgage. So the question then becomes, why would any borrower want to do that?

A Need to Qualify: Some borrowers may qualify for a loan with an IO who could not otherwise qualify. The IO payment is lower than the FA payment, reducing the ratio of housing expense to income that lenders use in qualifying borrowers.

However, qualifying a borrower with an IO who would not qualify with a FA mortgage is an artifact of somewhat archaic qualification rules. These rules are becoming increasingly flexible, and my surmise is that this rationale for the IO will disappear in time.

Anticipating Income Growth: It is common for families to begin with a "starter house", then move into a more expensive house as their incomes rise. This process of "trading up" carries high transaction and moving costs.

If you are fully confident that your income will rise, you can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but the IO mortgage may make it doable. Ask yourself whether you are comfortable with the risk that the expected higher income doesn’t materialize.

Need for Flexibility: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. They can make the IO payment when their finances are tight, and when they are flush they can make a substantial payment to principal. Ask yourself whether you are disciplined enough to make that payment when you aren’t obliged to.

Attractive Investment Alternatives: I know someone with a small but growing business that absorbs all his time and all his money as well. If he borrows to meet his business needs, it will cost 12-13%, or about twice as much as he can earn repaying his mortgage. Taking an IO mortgage allows him to borrow less to meet his business needs. It pays to owe more at 6% if it allows you to owe less at 12%.

The risk is that if his business fails, he is left with a larger mortgage. You need a lot of confidence in yourself to take this route.

The same could be said of taking an IO in order to invest in the stock market. It might make sense if you have confidence in your ability to pick winners. But don’t get hustled into it by a "planner" looking to earn a commission on both your mortgage and your investments.

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