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Interest-Only Mortgages Aren't for Everyone

November 4, 2005

By: Jim Oosterman
Melrose Bank

Homes in Melrose are expensive, 25% more than the state average. So, how can you afford the house you really want? In the last few years there has been resurgence in interest only mortgages. These types of loans now represent 11 percent of all mortgages in the country.

The idea is certainly not a new one. In the Roaring Twenties, interest-only loans were very common. The economy was doing well, so after a borrower completed their interest only term, they would refinance. This was a good idea except if you lost your job or if your home lost value. That is exactly what happened when the Great Depression hit. New interest only loans came to a complete halt, and foreclosures skyrocketed. Since then the economy has gone through many changes, which brings us to today.

How They Work
Interest only mortgages offer a reduced payment for the first five (or so) years by simply paying just the interest. After the five-year term you will make up the principal you didn't pay in the previous years. That means that you have to play catch up with your principal, which raises your monthly payments substantially. Suppose you have a $200,000 interest only mortgage, set for a 30-year term. For the first five years, the adjustable rate is set at 4.75%. Your monthly payment is going to be $791, which is $250 a month less than if you went with a traditional adjustable rate mortgage. While that seems like quite a deal, the downside of interest only loans is that after five years, the interest rate generally changes to a fixed rate for the remainder of the loan term and that will be higher. You could easily be paying twice the previous amount between the higher interest rate and adding in the principal payment. Over the course of the loan you would wind up paying approximately $262,000 in interest, versus $242,000 in interest with a standard adjustable rate mortgage. Those who aren't prepared for the drastic increase will run into a financial dilemma.

Who They Are For
An interest-only loan might work for:

  • Borrowers whose income is mostly from commission-based sales or bonuses and who will make additional payments to principal as their income allows
  • Borrowers who expect to receive a substantial increase in their income within the next five years in order to cover the “payment shock.”
  • Someone who will invest the savings by not paying the principal, and is certain that investment will be profitable (a risky proposition at best!)
  • Borrowers who plan on selling their current home within the next five years, thus investing in the real estate market

Although interest only mortgages can financially cripple unprepared borrowers, there are some who may benefit from this type of loan. Borrowers who want to take their additional cash flow and invest it, such as to fund a retirement plan. Most people don't fully fund their 401(k), for example. That extra several hundred dollars a month, can be channeled into a 401(k), giving them greater tax advantages while retaining the tax deductibility of their mortgage.

Those who are investor savvy can take the money saved and invest it in order to realize greater long-term gains than if it went to their mortgage. Another strategy would be to simply save the money you would have spent on principal each month and set it aside. That would at least soften the blow you will have to take in five years.

Recently, lenders began to offer loan terms of up to 40 years (compared to the former maximum term of 30 years.) By extending the length of the loan from 30 to 40 years, a borrower can decrease the mortgage payment by as much as 12 percent and still pay down the balance with regular payments to principal. That same $200,000 loan at 4.75% for the first five years would drop the payment from $1,043 down to $931. The added term does have its downside, however. The added 10 years to this mortgage increases the total interest paid to $354,000. Then again, very few borrowers are likely to keep their mortgage for the full 40-year term, and the initial monthly savings can be a big boost to making the monthly payments.

For some, interest-only loans can be a way to afford the house they desire, while focusing on getting the most out of their savings to prepare for the jump in payments. For the rest of us, it would be safer to stick with the other more traditional mortgage alternatives.

James Oosterman is the Vice President of Melrose Bank. He can be reached by telephone 781-665-2500, online at melrosebank.com or on Facebook at facebook.com/MelroseBank.


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