NEW YORK (MONEY Magazine) - Imagine your bank cutting your mortgage payments by 20 percent now in exchange for higher payments 10 years later -- by which time you'll probably have moved anyway.
Sweet, right? That's the appeal of interest-only mortgages, which in just over two years have gone from a novelty to 10 percent of the total mortgage market.
They work like this. Say you're considering a $200,000 adjustable-rate mortgage (ARM) with a fixed 4.32 percent rate for five years. An interest-only ARM would carry a slightly higher rate but also delay repayment of principal for up to 10 years. Your monthly nut becomes $746 instead of $1,011.
The catch -- and it's a doozy -- is that if you don't sell or refinance within 10 years, the principal comes due and your payments can balloon by 50 percent or more.
They have their uses
Interest-only mortgages can be useful for investors or people who expect to be earning much more in the future (a doctor near the end of his residency, say). Some advisers even recommend them as tools for retirement savings, suggesting you use what you save on your monthly mortgage payments to fund your 401(k).
But there are risks. "There are people using this to buy more house than they can afford," says Michael Moskowitz, president of New York mortgage lender Equity Now.
Perhaps the biggest danger is tied to the chance of a downturn in home prices. Say prices fall 25 percent, as they did in Houston in the mid-1980s. A borrower who purchased his home for $250,000 would be unable to move without taking a big hit. With the house now worth only $187,500, he'd lose his entire $50,000 (20 percent) down payment.
Once you tack on a real estate broker's 6 percent commission, the actual revenue from the sale would be only $176,000. That's $24,000 less than the mortgage. The homeowner would face a brutal choice -- sell and somehow come up with the $24,000 to pay off his mortgage or hold on and swallow a huge increase in his monthly payment.
Financial planner J. David Lewis sees pitfalls even if real estate continues to appreciate. An interest-only mortgage may give a young couple the ability to buy into a fancy neighborhood, but it won't give them the dollars to afford to live there.
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"Buying a house that's beyond your means brings a whole raft of other expenses with it," says Lewis of Resource Advisory Services in Knoxville, Tenn.
"You've got to have a different car to live in that neighborhood. Maybe you have to join a certain country club. It goes on and on...What you're doing is setting a pattern in your lifestyle that will make it harder and harder for you to save money and, ultimately, build wealth."