Interest-Only Mortgages: Home Free Or Homeless?

By Robert Stammers AAA

Interest only (IO) mortgages are popular among lenders and borrowers due to their ability to allow home owners to finance homes with mortgages they might not otherwise qualify for. These loans, which require smaller monthly loan payments than conventional, principal-repaying loans, can be a great benefit to first-time homeowners or borrowers expecting significant increases in their disposable income. However, these loans can also become risky for borrowers who mismanage their finances.

In this article we'll discuss how this type of financing may affect the borrower's fiscal situation and compare it to conventional financing.

Rationale for Lenders
Adjustable-rate mortgages (ARMs), which have initial payments that are often significantly smaller than their eventual fixed-rate payments, played a large part in the increasing loan default rates that occurred during the subprime crisis of 2007. Borrowers who bet that their incomes will grow at least as fast as the increase of their mortgage payments may find they can't afford the yearly rate adjustments or the higher fixed-rate payments. (To learn more on the subprime crisis, see Special Feature: Subprime Mortgages.)

The monthly payments on IO mortgages are lower than those on comparable principal repaying mortgages because they don't require a payment of principal during a portion of the loan period. Loan proceeds may be increased by lenders to allow borrowers to qualify for loans that are much larger than a comparable conventional mortgage. In the United States, IO mortgages tend to be structured as 30-year loans that have either five or 10 years of interest-only payments. Then, the payments fully amortize over the remaining life of the loan. Interest rates typically float during the interest-only period and will often adjust in reaction to changes in market interest rates.

The interest rate on an IO mortgage is often higher than rates on a conventional mortgage. Interest-only loans also tend to be subject to higher default risk than conventional loans. Furthermore, lenders may have more to lose if a borrower defaults on an IO mortgage compared to a conventional mortgage because the borrower pays the principal back to the lender. In the worst-case scenario, any reduction in the home's value could make the borrower unable to make payments, even after selling the property. It will also keep borrowers from being able to refinance the property when the loan matures. Therefore, to compensate lenders for this default risk, the borrower is subject to a risk premium over conventional principal repaying loans. This risk premium takes the form of higher interest rates.

This default risk can be offset by this loan's potential to reduce prepayment risk. When the market believes that future defaults are on the decline, some lenders, especially those that securitize these mortgages, will offer the loans at reduced spreads because of their ability to increase yield to maturity (YTM) and affect the value of 'A' rated bond tranches with yields that are are directly impacted by prepayment.

Interest Only Vs. Conventional Mortgages
It is important to understand how the IO payment structure compares to its principal repaying alternative. Consider two loans with the following terms. For comparative purposes, an IO loan that excludes a principal repayment period will be used.


A $200,000, 30-year fully amortizing conventional principal paying loan with a 5% interest rate as compared to a $200,000 30 year interest only non-amortizing loan with the same interest rate would produce the following financial outcomes:

Item IO Loan (A) Conventional Loan (B) Difference (A-B)
Monthly Payment (Principal and Interest) $833.33 $1,073.64 -$240.31
Total Interest Paid $300,000.00 $186,511.57 $113,488.43
Total Principal Paid $0.00 $200,000 -$200,000
Principal Balance at Maturity $200,000 $0.00 $200,000

In this scenario, a person taking the interest-only option would pay $240.31 less per month, an additional $113,488.43 of interest over the life of the loan and, at the end of 30 years, would still owe the original $200,000 that was originally borrowed. The principal balance of an amortizing loan decreases over time and because interest costs are based on the outstanding principal balance, the borrower of an interest-only loan faces the possibility of paying a significant amount of additional interest on the loan.

Benefits for Borrowers
The advantage of this type of financing is that it allows borrowers, not the lender, to determine the appropriate and achievable amount of equity to be accumulated over the loan period. Thanks to the deductibility of mortgage interest, mortgage loans are one of the cheapest sources of capital. However, the high monthly outlay to service these loans may occasionally force some homeowners to use more expensive short-term borrowing such as credit cards and retail credit facilities to make ends meet. By using an IO mortgage as part of an overall financial plan, homeowners can use the principal payment flexibility to periodically reduce the expense of short-term borrowings. The key word here is "periodically", because suspending the planned payment of principal on a regular basis can easily become an excuse to consume and potentially fall deeper in debt. (For related reading, see The Mortgage Interest Tax Deduction.)

Another advantage of the interest-only loan is that it can help soften the impact of life changes that negatively affect disposable income. Conventional mortgages can be a significant burden for people when available cash is reduced. Examples of these are the loss of a job, a business interruption, or a large unforeseen expense. If a temporary reduction of disposable income occurs, interest-only mortgagors can suspend the principal payments on a mortgages, freeing up cash to help them get homeowners through a downturn. Someone with enough financial self-discipline to follow a well thought out financial plan can prepay an appropriate amount of principal over time to accumulate the desired and achievable amount of equity in a home, but for others, mismanagement of this strategy is likely to lead to further financial instability.

Risks for Borrowers
Solely relying on an IO mortgage will impede the accumulation of equity in your home, which can be a source of wealth and a component for financial independence as one nears retirement age. The undisciplined borrower who plans to make increasingly large principal payments over the life of the loan finds that the inability to stay with a payment plan can lead to overpaying the desired amount of interest. When the mortgage matures, the borrower risks owing a balloon payment that is greater than was originally anticipated. IO financing requires introspection in order to gain an understanding of one's financial management skills. It is this type of due diligence, when entering into an interest-only loan or any other financing, that will keep one safe from financial pitfalls.

Ideal Borrowers
What type of borrower should consider IO loans? A young, first-time homeowner is likely to use an interest-only home loan, but is also most likely to run into problems if earnings do not grow in step with the increases in mortgage costs. A professional with an unpredictable income or earnings with a large variable component can be adequately suited for this type of loan. For example, professionals who earn large bonuses as part of their annual compensation benefit from lower monthly payments and can use the large lump sum distribution as the capital for paying the planned amount of principal. Professionals such as brokers who work on a commission structure and whose incomes can fluctuate dramatically from year to year can certainly benefit from the flexibility to pay principal when the income is available.

There is one situation where a borrower may consider entering into an IO mortgage without the intention of ever making a principal payment before maturity. For real estate investors/speculators, IO loans can be an exceptional way of using other people's money to take advantage of a strengthening real estate market. (To learn more about real estate investing, see Exploring Real Estate Investment Tutorial, Investing In Real Estate and Five Things Every Real Estate Investor Should Know.)

By using IO loans for housing projects, investors keep the current operating costs as low as possible and maximize their profits. Cash that otherwise would have been used for principal repayment is used for other expenses or used to upgrade the property to maximize value when the real estate market in that area reaches its peak. By selling the property at maximum value and then repaying the loan at that time, investors can potentially realize outstanding rates of return due to the relatively low amounts of their own capital invested in the deal. However, the whole strategy can collapse if the housing market for that area goes into a downturn. The speculator may run out of money to pay the monthly payments before he manages to sell the property at a decent price.

Conclusion
IO loans are a type of financing that requires lenders to be more prudent in their underwriting to assure that the rewards outweigh the risks of default. For borrowers, the ability to suspend principal payments periodically to assist in the initial qualification of a home loan or in order to insulate them from unexpected reductions of income are benefits that will lead many to consider interest-only loans. However, with the exception of real estate investors who will use lender capital to take advantage of local spikes in real estate values, borrowers using this particular financing must make sure to assess their abilities to stay within a financial plan and not use their home loans as an inexpensive way to bankroll excessive spending habits.

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