Interest Only First Mortgages

Over the course of the last twenty years or so, mortgage lenders have been creating new and innovative ways to assist first time home buyers in obtaining financing. One of those innovations is called the “interest-only” mortgage. Interest only first mortgages are touted as being highly affordable and easy to obtain, especially for those unable to secure traditional financing. However, as will be explained in this article, it is the opinion of this writer that interest-only mortgages are a trap to be avoided.

What is an interest-only mortgage?

An interest-only mortgage is one in which the borrower pays only interest and no principle for a set period of time; say the first ten years of a thirty-year mortgage. Beginning with the eleventh year of the loan, monthly payments are based upon amortization of the principle over the remaining twenty-year life of the mortgage. Interest-only mortgages are generally structured with adjustable rates, at least within the initial interest-only period.

Why are interest-only mortgages so attractive to home buyers?

Crafty mortgage lenders advertise interest-only mortgages as a means of purchasing a house with very low monthly payments to start. One such company that began offering these mortgages several years ago advertised the possibility of purchasing a $200,000 house with a monthly payment of less than $500. At first glance this seems like a great deal for first time home buyers. What they don't understand is that the devil is in the details.

Especially susceptible to this type of marketing are first time home buyers with credit problems or insufficient income for the house they desire. They look at the interest-only mortgage as a means to get the house they want, assuming that in the future their income will increase to a point where they can afford higher monthly payments. In some cases everything works out in the end. Unfortunately, the more common scenario sees a home buyer in worse financial condition ten years down the road than he or she was in when first purchasing the house.

Why are interest-only mortgages such a trap?

First and foremost, it is the nature of man to live right at the very edge of his means instead of below it. A home buyer who chooses an interest-only mortgage based on the fact that it will afford them lower monthly payments has already adopted the reckless attitude of stretching their finances to the very edge. It's easy to say that you'll be able to afford higher mortgage payments in ten years, but the reality is, lack of financial discipline will cause that ten-year period to expire before the ill-prepared home owner is truly ready for it.

Another part of this trap that home buyers fail to realize comes in the form of equity. Because nothing is being paid towards principle during the first term of the interest-only mortgage, the homeowner is building no equity. Should real estate values decline or remain flat during the interest-only term, it becomes all that more likely that the homeowner will find themselves under water at some point during the term. Should they decide to sell the house near the end of the interest-only period, they probably won't be able to get a price high enough to pay the mortgage and all the related costs.

Finally, a third part of the trap of interest-only mortgages are interest rates that are considerably higher than those of a traditional mortgage. This is not without purpose. The lender charges a higher rate of interest because the interest-only borrower poses a higher risk. Traditionally, those who choose an interest-only mortgage do so because of past credit problems. Such borrowers have a history of financial negligence and are therefore a higher risk to the lender.

While the borrower may see substantially lower monthly payments during the interest-only term, when those payments are compared against the interest paid on a traditional mortgage, they are actually paying substantially more. Making matters worse is the fact that interest is amortized over the life of the loan. Amortization begins during the second term of an interest-only mortgage; let's say at the eleventh year, so the interest on the principle “starts over” so to speak, at the beginning of the loan's second term. In essence, the home buyer ends up paying extra interest for the privilege of having an interest-only mortgage.

Does it ever make sense to get an interest-only first mortgage?

Real estate investors are one example of home buyers who can make the interest-only mortgage work in their favor. An investor may wish to purchase one or more houses to add to his portfolio, but lacks the upfront cash to make it happen with traditional loans. An interest-only mortgage allows them to purchase the homes and get them rented with the least amount of cash. The subsequent monthly rental payments will generate the much needed cash flow to keep going. After a year or two, the owner has enough cash generated to be able to make extra payments against principle. Those extra payments bring the interest down so that the cost of the interest-only mortgage becomes negligible.

Another example of a homeowner who might benefit from an interest-only mortgage is a young person with a substantial amount of money left in trust for future use. If that person's trust becomes available during the interest-only term, that money can be used to pay down principal or be laid up in store for future payments at the end of the interest-only term. In such cases, it might also be possible for the homeowner to refinance at the end of the interest-only period into a traditional thirty-year mortgage.

While interest-only mortgages may seem attractive they should be embarked upon with the greatest of caution. Too many things can go wrong from the perspective of the buyer, especially in the current volatile housing market, and he/she could end up losing everything.

There's an old adage that says anything worth having is worth working for. That's certainly true when it comes to buying a house. If a home is worth owning it, it is also worth working and saving for, rather than taking an unnecessary risk with an interest-only mortgage.