So you’ve heard of the latest magic pill in the home financing world – the interest-only mortgage. And you love the idea of making a lower monthly payment, getting a bigger tax deduction and having all that extra cash now. Not to mention actually being able to buy your dream home.

Interest-only mortgages accounted for less than 2 % of all U.S. home loans as recently as 2001, but by 2005 had shot up to 23% nationwide and as much as 47% in the major cities. (Coy 2005, Downey 2005) And if aggressive marketing is any indicator, the trend is not going away anytime soon.

But remember all those television commercials of happy people running through meadows in spring, thanks to the latest wonder drug for acid reflux or arthritis? There’s always the rapid voiceover at the end, “Possible, but rare side effects include death, blindness, permanent brain damage, limbs falling off…”

You don’t want to be those rare statistics. So let’s take a look at the good and bad side effects of this particular magic pill and who really needs to take it.

Firstly, like the cure for the common cold, the interest-only mortgage does not exist. What does exist is the interest-only-for-some-years mortgage.

“The mechanics of an interest-only mortgage loan are simple. For a set period (generally in the early years of a mortgage when most of the payment goes toward interest anyway), you pay only the interest portion of your monthly payment, freeing up for other purposes the amount that would normally go toward paying off the principal. At the end of the interest-only period, your loan reverts back to its original terms, with the monthly payments adjusted upward to reflect full amortization over the remaining years of the loan…” (MacDonald 2004)

So with an “interest-only” loan, you would be making lower monthly payments than those for a standard fully amortized loan of the same amount and duration, during the initial interest-only period. When the interest-only period ends, your monthly payments will rise to be higher than those for the standard loan. This is because you have the same balance you started out with, but now have only, say, 25 years to pay it off, as against 30 years for the fully amortized loan.

This is not a new idea. The heyday for interest-only mortgages was the 1920s flapper era.

“…Back in the Roaring Twenties, interest-only mortgages were commonplace. At the end of the term, homeowners typically refinanced. The system worked great unless your home lost value or you lost your job.” (MacDonald 2004)

So what are the pros to this approach?

1. You have more immediate money at hand, which can be invested for higher returns or used to re-model the home and increase its value. “For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.” (Guttentag 2006)

2. You can reduce your cash outflow temporarily, if a financial crisis strikes. For example, a person who’s been laid off might find this useful.

3. Interest-only loans often have more flexible payment options than standard loans. Every month, you could opt to pay interest only, or pay towards the principal, or even pay off the principal quicker than the typical 30 years. If you have fluctuating income and are disciplined enough to voluntarily make higher payments when you can, these options might help you pay off your loan quicker and with less pain.

4. You can borrow more money at the same initial monthly payment as that for a smaller standard loan, allowing you to buy a more expensive home than you would have been able to with the standard loan.

And the cons?

1. You can borrow more money at the same initial monthly payment as that for a smaller standard loan, allowing you to buy a more expensive home than you would have been able to with the standard loan.

You are more in debt and might own a home you can’t afford. This is the grasshopper philosophy of not saving up for a rainy day, on the assumption that your home price and/or income will rise. And summer will never end.

History, that harsh teacher, has a different lesson. Remember what ended the glory days of the1920s? The Great Depression with its stockmarket crash and massive job losses. No prizes for guessing what happened to all those interest-only homes. Foreclosure.

In more normal times, while nationwide average home prices have been rising, home prices in any given market go up and down. If your plan were to re-finance or sell your house after the interest-only period, your home price would have to rise enough to cover the sales costs, since not paying off the principal gives you little equity. Even in the most desirable home markets, that does not always happen.

2. You pay more in interest as compared to a standard loan. For a $120,000 loan, an interest-only payer would pay about $8000 more than a fully amortized payer over 30 years, because the interest-only balance tends to remain higher. (Hsh.com 2005)

3. Lenders also usually charge higher rates for interest-only loans, since these loans, with their larger balances, are considered riskier.

“…fixed-rate interest-only mortgages typically carry a rate that is one-eighth to three-eighths of a percentage point higher than the rate on a traditional 30-year fixed-rate mortgage.” (Simon 2006)

4. While interest-only payments are 100% tax deductible, the money saved will still be taxed, whether it’s put in the bank or invested. “Suppose 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.” (Guttentag 2002)

To sum up, interest-only loans save you money temporarily, but are more expensive and more risky long-term. If you desperately need those temporary savings, or are wealthy enough to bear the risks, or are financially disciplined enough to pay off the balance when you can, then these loans might be for you. But if losing the gamble might mean losing all your savings, then it’s probably a game you don’t want to play.

Cheryl Kanekar is an experienced free-lance writer who focuses on mortgage refinance and equity credit lines. You can read more refinance related loan articles at http://www.mortgageloanoutlet.com/ and get more information about home equity loans and mortgage refinancing.

Guttentag, Jack Interest-Only Mortgage Tutorial. Mortgage Professor’s Web Site from http://www.mtgprofessor.com/Tutorials2/Interest_Only.htm

HSH® Associates The Principal Facts of Interest-Only Mortgages from http://library.hsh.com/?row_id=58

Max, Sarah Mortgages: Beating Higher Rates from money.cnn.com Moyer, Liz. Beware The Interest-Only Mortgage from forbes.com Downey, Kirstin Many Buyers Opt for Risky Mortgages. Washington Post

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