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Starting with an interest-only loan
Should I get an "interest-only" mortgage when I buy my first home?
July 29, 2005: 2:47 PM EDT
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - I'm considering going with an "interest-only" mortgage when I buy my first home. Do you think this is a good idea?

-- Scott, Baltimore, Maryland

It's amazing how quickly interest-only, or IO, mortgages have gone from novelty items to virtual mainstream status. Five years ago, these loans accounted for less than 2 percent of the mortgages made in the U.S. By last year, however, about a third of home mortgages included an interest-only option, and in some hot housing markets experts estimate IO loans account for upwards of 70 percent of new home loans.

That surge in popularity is hardly surprising. If you're initially paying only interest on your mortgage, your monthly payments are about 20 percent or so lower than what you pay with a conventional mortgage that also chips away at principal each month.

That lower payment frees up cash that you can use for other things. Or you can keep the payment the same size it would have been with a conventional mortgage and thus get a larger loan and a bigger house.

The risky advantage

But those advantages come with some risks. An IO loan lets you off the hook for principal payments only temporarily. Depending on the specifics of the IO loan you get, typically five, or seven or 10 years down the road you'll have to begin paying off principal.

And when those principal payments kick in on top of the interest payments, the payment will jump way beyond the payment you would have had with a regular principal-and-interest loan since you now have to repay principal in a shorter number of years.

The result is that your monthly payment can jump 40 to 45 percent. And if your IO loan carries an adjustable rate, the increase could be even steeper since you could face the double-whammy of the principal payments kicking in plus a higher interest rate.

Look before you leap

Given the potential havoc such an increase in monthly payments can wreak, I wouldn't be too quick to jump at the IO option. But you might consider it, say, if you have good reason to believe your income is likely to increase enough between the time you take out the mortgage and the time you must begin making principal payments so you'll be able to handle the higher payments.

You might also think about going with an IO loan if you think you can really take advantage of the lower monthly payments, such as using the extra cash to pay off higher-rate credit-card or other debt or paying college expenses for your kids. Or you might consider an IO mortgage if you think you'll likely sell the house by the time you have to start paying principal or shortly thereafter.

But be realistic. If your estimate of a higher salary just reflects your natural optimism as opposed to some more concrete assessment of your prospects such as actually being on track to a significant promotion, you may be setting yourself up for problems. Similarly, you should ask yourself whether you're really likely to pay off existing debt as opposed to living an unsustainable lifestyle.

I'd be especially wary of taking out an IO loan if I were counting on interest rates to remain flat or fall so I could handle the future payments.

Similarly, I wouldn't want to be depending on a continued boom in house prices as my escape hatch. Maybe rates won't go up appreciably the next few years and maybe home prices will continue to rise steadily. But I wouldn't want to put myself in a position where I'd be jeopardizing my financial security if those things don't happen.

Do your research first

If you still think you're a candidate for an IO loan, I recommend you first read an earlier column I wrote on this subject as well as a story that appeared earlier this year in MONEY Magazine.

I also suggest you read the interest-only tutorial at the Mortgage Professor Web site run by Jack Guttentag, an emeritus professor of finance at Penn's Wharton School.

Finally, don't be shy about asking the lender to project your mortgage payment once principal payments are required. And if the IO loan has a variable rate, have the lender run scenarios at a variety of rates.

Who knows, maybe everything will work out in your favor and an IO loan will turn out to be the best financial decision you ever made. But just in case, it's always good to have a sense ahead of time of what the downside might be so you can decide whether you feel you can handle it.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page


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