Could you handle an interest-only loan?

Liz Pulliam Weston

They sound too good to be true, allowing buyers to free up cash or to buy more house. The catch? Zero equity for years -- and then monster payments.

How would you like a mortgage that either significantly lowered your monthly payment or allowed you to buy a lot more house?

An interest-only mortgage can do either, and lenders increasingly are touting them as the answer to many borrowers' prayers. Whether these loans turn out to be a blessing or a curse, though, depends a lot on who's doing the borrowing:

  • If you're a disciplined investor, good with money, a bit of a risk-taker and not buying more house than you can handle, an interest-only mortgage could work for you.
  • If you're not all of those things, you probably want to stick to a more plain-vanilla mortgage.

"It's a bad idea for someone who can barely afford the house they're buying," said Brad Blackwell, national sales manager for Wells Fargo's West Coast mortgage operations. "If you're using the extra money to put food on the table, it's better to get a (more conventional) loan."

The catch

Most mortgages require that you pay back some principal with each payment -- a little bit at first, a lot more as time passes. Interest-only loans skip that requirement in the early years of the loan so that none of your payment goes toward paying down principal. The result is a significantly smaller initial payment compared with other options, such as a 30-year fixed-rate mortgage or a hybrid loan whose rate is fixed for the first five years:
How payments differ on a $500,000 mortgage

Mortgage type



Five-year interest-only



Five-year hybrid



30-year fixed



* Assumes loan is amortized over 30 years, but rate is fixed only for the first five years.

Like regular mortgages, interest-only loans come in many different forms. The rate can adjust annually or be fixed for a while (usually five, seven or 10 years) before becoming variable. The interest-only portion may end after the fixed period, or it may continue for a few more years before principal payments are required. As with other adjustable-rate mortgages, there are typically caps that determine how much your interest rate can rise each year and during the life of the loan.

Here's how it might work for a five-year, interest-only loan:

  • Your payments would be fixed for the first five years at a certain interest rate -- say, 3.875%.
  • For the next five years, you still might pay just interest on the loan, but the rate would be variable and could increase by two percentage points every six months, up to a cap of 9.875%.
  • In the 11th year, the rate remains variable, but the loan requires you make both principal and interest payments.

Nobody can accurately predict future interest rates. But this is an example of what you might pay on a $500,000 mortgage if the rate started at 3.875% and jumped three percentage points in the sixth and eighth years:

How payments can change on an interest-only loan



Monthly payment

1 to 5



6 to 8



8 to 10



10 to 30



* Interest only **Includes amortization of principal over 20 years.

As you can see, the monthly cost can climb steeply, especially once you start paying back principal. You could end up paying a lot more each month than if you had stuck with a 30-year, fixed-rate loan.

Not a long-term proposition

Interest-only loans make the most sense when you're borrowing a big chunk of money. At smaller loan amounts, the savings might not offset the loans' greater risk.

And interest-only loans aren't really meant for the long haul. Lenders say most borrowers who get them expect to either sell their homes or refinance before the interest-only period ends.

"The typical time in a home is five to seven years" before the owner sells or refinances, said E-Loan CEO Chris Larsen. "For someone who does end up staying in the home for 20 years, they might not like what they see in year 11."

Opting for an interest-only loan now means you're passing up the chance to lock in today's low interest rates. If you wind up owning the home a long time -- say 10 years or more -- you may wish you had opted for that fixed-rate loan.

Interest-only loans were popular in the 1920s, when borrowers wanted to free up money for stock investments. The 1929 crash and subsequent foreclosures ended that particular party, but in the decades since then, private banks made interest-only loans available to their rich clients. These borrowers tended to have plenty of real estate exposure in other investments, were sophisticated about managing the risks and didn't care about building up equity in their homes.

In the past few years, however, spiking real estate prices -- and increasingly risk-tolerant borrowers -- helped spark a revival for mass-marketed interest-only loans. Wells Fargo introduced its version three years ago, followed by E-Loan and other major lenders. Interest-only loans currently make up about half of the adjustable-rate mortgages that E-Loan brokers, or just under one in six loans the online lender makes overall; other lenders report similar surges in interest.

"The market is really people on both coasts," said Wells Fargo's Blackwell, "places where loan amounts are higher because of high real estate prices."

Who chooses interest-only loans?

Interest-only borrowers, lenders say, come in two basic types:
  • The upwardly mobile. These people are stretching to buy more house, since the same payment on an interest-only mortgage will buy about 20% more house. Translated, that means someone who could qualify for a $500,000 house on a traditional 30-year fixed-rate mortgage might be able to land a $600,000 place with an interest-only loan. Many of these folks expect their incomes to rise sharply in a few years, and they want a bigger home now, rather than waiting to trade up.
  • The cash-flow crowd. Others want the smaller payment, for whatever reason. They could be investing the difference, or they might be business owners or commissioned salespeople with irregular incomes, said Washington Mutual executive Lenny McNeill. These borrowers want a smaller payment for the lean months, while being able to pay down their principal in big chunks when the money comes in.

Then again, a growing number of borrowers are content to let rising markets build their equity for them, McNeill said. They don't want to tie up more money than they have to in their mortgages. They figure they can get a better return on their money investing it somewhere else.

"They're more savvy, more experienced, more knowledgeable about finances," said McNeill, head of Washington Mutual's Southwest regional consumer group. "They more clearly see the benefits."It's a strategy that works very well while home prices soar, not so well when markets stall or tank. If you have to sell when prices are down and you haven't built up sufficient equity, you could take a big loss.

You also could find yourself poorer in the long run if you aren't disciplined. Millions of Americans have built up their wealth over the years by paying down their mortgages. If you skip that step and just spend the extra cash instead, your overall net worth will suffer.

The interest-only solution can work for awhile, but eventually most Americans will want to own their own homes -- not just rent them from the bank.

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