The Fallacy of So-Called Interest-Only Loans

So-called "interest-only" loans are all the rage right now, but they'll get many borrowers into hot water if interest rates begin to rise quickly. First of all, the phrase, "interest-only", is a fallacy. While the borrower is not required to pay back any principal at first, beginning somewhere around year five to year eight, he/she must begin paying back the principal. For example, let's say the required principal payback period on a 30-year mortgage begins in year six. From then on, he/she would be required to pay back 1/25 of the principal ($10,000 on a $250,000 loan) annually.

Now, if the borrower does not expect to keep the house very long and is looking for quick run-up in price before selling it in a few years, some lenders and mortgage brokers will push these interest-only loans. They use the initially low payments as an enticement. These types of loans would ultimately be the best choice if (1) the price run-up actually occurs and (2) interest rates remain relatively low.

Many experts are predicting that the real estate "bubble", which led to sharp increases in property values over the last several years, will soon burst, leaving some property owners with mortgages that exceed their actual property values. Even those with conventional loans would be adversely affected by such a downturn. But interest-only mortgages present an additional danger, even if such a downturn never comes to pass.

If interest rates rise quickly, borrowers might not be able to get out from under their interest-only mortgages so easily before their payments considerably increase (by $333 per month on just a $100,000 mortgage, using the example above). That's because interest rates might be so high that (1) they may not be able to afford new/refinanced mortgages and/or (2) they may not be able to find anyone who can afford to buy their current houses.