In recent years, banks have been marketing interest-only mortgages to a crowd of buyers that want bigger houses, but couldn't otherwise afford it. Interest-only mortgages allow home buyers to pay a monthly payment that consists of only interest, no principal. [1] The option to pay only interest lasts for a specified period of time that usually lasts from five to ten years.[2] Using a traditional mortgage a home buyer would be required to make a fully amortizing payment which requires payments of enough interest and principal for the loan to be paid off over the term (i.e. 30 years).[3] What gets the interest-only buyer in trouble is two-fold: no financial cushion in the event of unplanned expenses, and the termination of the interest-only period.

If there is ever any shift in financial circumstances, the interest-only borrower presumably already on the periphery of financial stability has no home equity to fall back on. There are a range of things that could change financial circumstances from illness to car trouble to losing a job. When things get rough financially for the average home owner, they typically have at least the equity in their home to fall back on. The interest only home owner has not paid any principal and has zero equity.[4] Realistically speaking, the bank paid for the house and the "home owner" is merely making rent payments in disguise while still assuming the risk associated with homeownership.

Secondly, if the interest-only borrower makes it through the interest-only period without getting tripped up by life's financial changes, that borrower will still have to contend with the termination of that interest-only period and the accompanying higher monthly payments.[5] The payments on the loan will still be measured against the originally-determined term.[6] For example, if a borrower gets a $500,000 loan with a 30 year amortization and pays interest only for the first 5 years, when the sixth year hits they will have to make payments that would be equal to a traditional mortgage of $500,000 with a 25 year amortization.[7] This means that the borrower's monthly payment is even higher than the traditional loan payment they could afford 5 years ago.

To be fair, there are some borrowers that are good candidates for interest-only mortgages.[8] Since you are allowed to make a higher payment than is technically due on an interest-only mortgage, a person with a fluctuating income can make higher payments when his income stream is high and interest-only when his income is low.[9] This would work out as long as the borrower had the sophistication and discipline to make the higher payments even though he doesn't have to. Also for those who are sure to have a substantially higher income after the interest-only period, this type of loan will allow them to skip the starter house and avoid the transactional cost associated with trading up.[10] The problem is that most people tend to be overly optimistic about how much higher their income will be in the future, so they could be setting themselves up for failure.

With the risk of financial trouble so high because of wanting more than what is affordable right now, it is amazing that banks are encouraging this type of homeownership to people who could not afford a larger home otherwise. For a few buyers interest-only mortgages can be a rational financial decision. But for most, interest-only mortgagors are merely engaging in overextended, microwave generation borrowing.

[1] The Principal Facts of Interest-Only Mortgages, HSH Associates Financial Publishers, at http://library.hsh.com/?row_id=58 (last visited April 4, 2007).

[2] Interest-Only Mortgage Tutorial, Mortgage Professor’s Website, at http://www.mtgprofessor.com/Tutorials2/Interest_Only.htm (last visited April 4, 2007).

[3] Id.

[4] Id.

[5] Ben Barros, Interest Only Mortgages: The Next Class Action Goldmine for Plaintiffs’ Lawyers, PropertyProf Blog, Oct. 21, 2005, at http://lawprofessors.typepad.com/property/2005/10/interest_only_m.html

[6] Mortgage Calculator, Interest.com: Your Financial Marketplace, at http://mortgages.interest.com/content/calculators/index.asp (last visited April 4, 2007).

[7] Interest-Only Mortgage Tutorial, Mortgage Professor’s Website, at http://www.mtgprofessor.com/Tutorials2/Interest_Only.htm (last visited April 4, 2007).

[8] Id.

[9] Id.

[10] Id.