Why the New Interest in Interest-Only Mortgages?

NOTE: IF YOU WANT THE CRITICAL FACTS ABOUT INTEREST-ONLY WITHOUT ANY FRILLS, GO TO THE INTEREST-ONLY TUTORIAL.

August 19, 2002, Revised December 11, 2006

"In looking to refinance my existing mortgage, I've found some lenders offering "interest only" loans. One lender is offering an interest only option for 10 years on all its programs. Since I plan to be in my current house for no more than 10 years, this seems attractive. The monthly payment is lower than for a fully amortized loan, and since the payments are all interest they're 100% deductible. Am I overlooking something?"

Yes, and I’ll tell you what it is in a moment.

A mortgage is "interest only" if the monthly mortgage payment does not include any repayment of principal. The payment is "interest only." So long as the payment remains interest only, the loan balance remains unchanged.

For example, if a 30-year fixed-rate loan of $100,000 at 6.25% is interest only, the payment is .0625/12 times $100,000, or $520.84. Otherwise, the payment would be $615.72, of which $94.88 is amortization. $615.72 is the "fully amortizing payment" – the payment that, if maintained over the term of the loan, will pay it off completely.

If a loan was interest-only for the full term, the loan balance would be the same at term as it was at the outset. Back in the twenties, loans of this type were the norm. Borrowers typically refinanced at term, which worked fine so long as the house didn’t lose value and the borrower didn’t lose his job.

But the depression of the thirties caused a large proportion of these loans to go into foreclosure. Lenders stopped writing them and have never brought them back. They want loans that eventually amortize.

Hence, the interest only loans of today are interest only for a specified period, usually 5 to 10 years. At the end of that period, the payment is raised to the fully amortizing level. In such case, the new payment will be larger than it would have been if it had been fully amortizing at the outset.

When I wrote about interest only loans a few years ago, most borrowers seemed to be viewing them as a way to afford more house. My conclusion at that time was that interest only mortgages were OK for that purpose, provided that borrowers were reasonably confident that they would be able to deal with a payment increase in the future.

As in your case, however, the splurge of interest in interest only mortgages today seems less related to affordability issues than to concerns about how best to manage personal finances. It is a healthy shift in attitude, provided that you are focused on the right objective. For most, that objective is to accumulate wealth during the working years to afford a comfortable retirement.

Wealth equals assets less debt. It is built up over the years, by accumulating assets and paying down debt, including (and especially) home mortgage debt. When you pay down the balance of your mortgage, you are increasing your wealth by reducing debt. But so long as you have an interest only mortgage, you are not increasing your wealth in that way.

Of course, you may be increasing your wealth by accumulating assets instead. If you have such a plan and you have determined that it is more effective in building wealth during the interest only period than paying down mortgage debt, fine. But for most homeowners, paying down mortgage debt is the most effective way to build wealth, especially in today’s financial environment.

Suppose you have a 6.25% mortgage and your financial plan calls for increasing your wealth this month by $100. If you put it in the bank, you may earn 2-4%, depending on the term. If you put it in bonds or stock, you may earn more, but you take a risk. If you use it to reduce the balance of your mortgage, you earn 6.25% before tax with no risk at all.

The tax saving on mortgage interest does not affect such comparisons because you must pay taxes on interest earnings. Suppose, for example, you are in the 39.1% tax bracket. Then your 6.25% mortgage costs only 3.81% after taxes, but a 4% CD yields only 2.44% after taxes. The investment that is most advantageous before taxes is also most advantageous after taxes.

If the borrower's income is so large that he loses some or all of his deductions, the after-tax return on mortgage repayment would be larger. It would be 6.25% in the case where he loses all deductions.

For most home owners, mortgage loan repayment is the best investment available. That’s why I’m skeptical about the recent flurry of interest in interest only mortgages. I’m told that much of the interest comes from relatively sophisticated borrowers, which is worrisome. A little sophistication can be a dangerous thing.

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