Does an Interest-Only Mortgage Amortize Faster?

May 21, 2009

Here is a typical loan officer pitch for an interest-only (IO) mortgage as related to me by countless borrowers:

“The payment on the 30-year 5.5% fixed-rate mortgage is $567.79 for each $100,000 of loan, of which only $109.46 is reduction of principal. On the IO, the rate is 3% and the payment only $250. If you make the $567.79 payment, $317.79 of it will go for principal. This means that you will pay off your loan much sooner.”

Everything in this statement is true, yet it is extremely misleading. The rate on the IO is not 3% because it is IO but because it is an adjustable rate mortgage (ARM). Rates are lower on ARMs than on FRMs because ARMs are riskier to the borrower. The real choice that is being made here is not between IO and non-IO but between FRM and ARM.

Borrowers making this choice do indeed have the option of taking the lower-rate ARM while making the larger payment. This is a good risk-reduction strategy when selecting an ARM because, if the ARM rate rises in the future, the payment increase won’t be as large. ARM borrowers can adopt this strategy, whether their ARM has an IO option or not.

Indeed, borrowers who plan to do this may do better with an ARM that does not have an IO option, because in many cases the rate will be lower. If the ARM in the example above were available at 2 7/8% without an IO option, the borrower would be better off selecting it. The sales pitch obscures this possibility.

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