The Perils of Interest-Only Mortgages

Just a couple of years ago you undoubtedly heard plenty of hype about interest-only mortgages. You remember them, don't you? With an interest-only mortgage, instead of a payment amount that's large enough to cover the monthly interest charged and pay down the outstanding principal of the loan, the monthly payment is reduced to only the amount of the accumulated monthly interest.

The advantage of choosing an interest-only mortgage is that with the smaller payment you'll have more money that can be saved, invested or used for other things. It will allow you to have more liquid cash on hand. A smaller house payment typically also helps borrowers with lower incomes to qualify for a mortgage. Of course, these loans also come with possible disadvantages. One major concern is that after you've paid for years on the home, you've built up no more equity than you had on the day of your closing. Only accumulated interest has been paid on the loan, and nothing toward the principal balance.

Most interest-only mortgages have adjustable rates, and the interest-only term is limited – generally to the first five- to ten years of the loan. With the American family moving an average of every seven years, the majority of borrowers seeking this type of loan don't intend to stay in the property any longer than the loan's interest-only period, hoping to sell before principal-and-interest payments become due. They usually also count on property appreciation to grow equity during their stay and keep themselves 'right side-up' in their mortgage. During the current housing market meltdown, however, things have not proceeded according to plan. Many families have seen the value of their home steadily drop, often to the point where they've found themselves 'upside-down,' owing more on the loan than the property's market value. With the looming prospect of even higher payments at the end of the interest-only term, and homes being more and more difficult to sell and thus 'escape' the situation, large numbers of borrowers have faced the devastation of foreclosure and the loss of their homes.

Some people count on investments that they've made and other monies to pay for everything in the end. Others may have savings programs of some type to ensure that the money needed to pay off the loan or refinance their home will be available when needed. But, if those financial plans don't work out as hoped, they too may find themselves having paid thousands upon thousands of dollars into an investment – only to see every bit of it slip helplessly away with the house.

Although widely touted just a few years ago as a great way to buy a home, interest-only loans are now considered to be, at best, a risky way to go. In the light of current market conditions, these loans are extremely difficult to find and qualify for. However, if you have a very solid game plan – a good entrance and exit strategy – for the property, an interest-only loan could still be to your financial advantage. But use it at your own risk.