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When The Interest Only Loan Makes Sense Staff - Mortgage Lenders Plus.com

Interest only home loans are not a new idea. In fact, such loans were standard during the boom market of the 1920s. When the Great Depression hit, however, foreclosures skyrocketed. That economic disaster made the long-term amortized mortgage -- the 30-year loan with a gradual pay-down of principal -- the U.S. favorite. Until recently, in this country interest-only was an option used only by real estate investors.

But as home prices have skyrocketed in recent years, banks have started to sell interest only home loans to home mortgage lenders for consumers. In most cases, customers pay a slight interest-rate premium for an interest-only option, anywhere from 1/8- to 1/2-percentage-point above the same loan with standard amortization. Banks also require higher credit scores to reduce the increased risk of an interest only loan rate.

There are so many of these loans in circulation today that mortgage insurers and the banks themselves are getting scared. Interest only home loans were designed for sophisticated money managers who understood the risk. There are now millions of American homeowners who are paying interest only loan rates because it was the only way they could afford a home. That fact is going to become a major issue if there is a protracted “adjustment in the housing market.

Financial planners agree that for homeowners with lots of assets, interest only home loans can be wise. There are no prepayment penalties on interest only loans, so homeowners always have the option of paying down the principal. Having
other savings or investments available would help absorb the shock if a homeowner had to sell at a loss. Some home buyers take out these loans because they believe they can invest what would be their principal pay-down at a better rate.

The popularity of interest only home loans also reflects the realization amongmany buyers that they will never actually own their homes. Nationally, less than half the people with 30-year mortgages stay in place long enough to pay off that loan. Some buyers fully intend to refinance at interest only loan rates and maintain the lowest possible house payment. They are more interested in building equity in other investments.

In addition to the wealthy, interest only home loans are feasible for people who fall into three other categories. The first are those whose income will jump, such as medical students. The second are those who are confident of their home appreciation. The third are those who know they are staying for only the short term, meaning they wouldn't pay down much principal anyway and will move before the interest-only period is up.

People who are betting on home appreciation to build their equity for them are probably the group most at risk. The end of the great housing run of 2000-2005 is going to put some of those people in financial jeopardy. When interest only loan rates adjust, the jump is enormous. If the house is still worth close to what the homeowner paid for it, refinancing won’t be an option. For those with the flexibility to sell, an interest only home loan will have made sense – provided the market cooperates.

But if you get out with just enough to cover your original closing costs, what’s the point? If you had chosen to rent, you could have called the landlord to fix those leaky pipes.