NOTE: IF YOU WANT THE CRITICAL FACTS ABOUT INTEREST-ONLY WITHOUT ANY FRILLS, GO TO THE INTEREST-ONLY TUTORIAL.

April 8, 2003

I continue to be dumbfounded by the claims about interest-only loans reported to me by mortgage shoppers. Whether the claims originate with loan officers or, as one defensive loan officer suggested to me, they arise in the over-active imagination of shoppers who still believe in the tooth fairy, I can’t say for sure. Probably it is some combination of the two. All I know for sure is that misperceptions abound, and I keep running into more of them.

Misperception 1: Interest-only loans are a type of mortgage. They are not. Interest-only is an option that can be attached to any type of mortgage.

For example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly payment of $599.56. This is the fully amortizing payment -- the payment which, if maintained over the full term of the loan, will just pay it off.

In month 1, that payment divides into $500 of interest and $99.56 of principal. In month 2, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After 5 years the balance is $93,054. That is how mortgages amortize.

Now lets attach an interest-only option to this mortgage, available, say, for the first 5 years. That means that the borrower need pay only $500 a month during the first 5 years. There is no payment to principal.

If the borrower exercises the option, therefore, the balance after 5 years is $100,000. There is no amortization. Beginning year 6, the borrower must begin paying $644.31. That is the fully amortizing payment for a 6% loan of $100,000 for 25 years.

Misperception 2: It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.

Suppose a borrower takes the mortgage described above with the interest-only option, but decides to pay $599.56. He doesn’t exercise the option but makes the fully amortizing payment instead. Then the loan will amortize just as it would have if the interest-only option had not been attached. After 5 years, the balance will be $93,054. If you make the same payment on the same mortgage, you end up in the same place.

If the borrower pays $700 a month instead of $599.56 on the same mortgage, the balance after 5 years will be $86,046. Whether the mortgage did nor did not have an interest-only option will matter not a whit.

Misperception 3. An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.

The notion that interest-only loans have lower rates arises from comparisons of apples versus oranges. Adjustable rate mortgages (ARMs) with an interest-only option have lower rates than fixed-rate mortgages (FRMs) without an option. But an ARM with the option does not have a lower rate than the identical ARM without it.

Since the interest-only option is available on both FRMs and ARMs, it is pointless to be sucked into an ARM because of that feature. First choose whether or not you want an ARM or an FRM. This decision should be based on how long you intend to have the mortgage, and on your willingness to accept the risk of a future increase in the interest rate in order to have a lower rate in the short-term. If you opt for an ARM, then select the other ARM features you want, including an interest-only option.

Misperception 4. On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. This might or might not be the case. Where it is not the case, this may be the most dangerous misperception of all because it can induce borrowers to take ARMs that don’t meet their needs.

The interest-only period is the period during which you are allowed to pay interest only. The period for which the initial rate holds is a different matter altogether. On an ARM with a very low rate, the interest-only period is always longer than the initial rate period.

A common ARM today has an interest-only option for 10 years, but the initial rate holds only for 6 months. On a $100,000 loan with an initial rate of 4%, the interest-only payment is $333. If the rate after 6 months goes to 6%, the interest-only payment would jump to $500. Borrowers who thought they were safe for 10 years would get a rude awakening.

November 20, 2003 Postscript

Misperception 5. Interest-only loans are appropriate if you don't expect to be in the house very long. I don't know where this idea comes from, but it makes no sense. If you don't expect to have the mortgage very long it makes sense to select an ARM because the rate will be lower, and it makes sense to avoid paying points because there won't be much time to recover your investment through a lower rate. But the decision to take an interest-only should not be affected by your time horizon.

February 10, 2004 Postscript

Misperception 6. Interest-only loans don't require PMI. Some loan officers are shameless in the stories they tell borrowers, and this is another one. Of course, some interest-only loans don't require PMI because the loan is too large relative to the borrower's equity, or the deal is otherwise sub-prime. In these cases, the borrower is paying the insurance in the interest rate.

If there is a loan that requires PMI but does not require it if the loan has an interest-only option attached, it would be because the insurer doesn't want the greater risk entailed by the PMI. In such case, the implicit insurance premium in the rate is bound to be larger than the PMI premium.