Interest-only mortgage deja vu

When my mailbox first started to fill with questions about interest-only mortgages a few years ago, I smiled; I knew a flash in the pan when I saw one. Interest-only mortgages were the standard mortgage in the 1920s, but they disappeared during the Great Depression, and for good reason. This sudden renewal of interest would not last -- or so I thought.

An interest-only mortgage is one that allows borrowers to pay only the interest for some specified period. The required monthly mortgage payment includes no repayment of principal, though borrowers can make such payments if they like.

For example, if a 30-year fixed-rate loan of $100,000 has an interest rate of 6 percent, the standard "fully amortizing" monthly payment is $599.56. This payment, if continued with the same interest rate, will pay off the loan at maturity. The interest-only payment, however, is only $500. The interest-only borrower saves $99.56; the borrower with the amortized loan puts that same amount toward repaying principal.

The IOs of the '20s were interest-only for their entire life, usually five to 10 years. This meant that the loan balance was the same at maturity as at the outset. Borrowers who were still in their houses would then refinance.

Foreclosures galore
This worked fine so long as the houses didn't lose value. However, the drop in real estate values during the Depression pushed a large proportion of interest-only loans into foreclosure. Lenders switched entirely to fully amortizing loans, and that has been the standard mortgage loan since.

The new breed of IOs differs from those of the '20s in two ways. First, they are not interest-only for their entire life, only for the first five or (more often) 10 years. At the end of that period, the payment is raised to the fully amortizing level. This appears to make them less risky than the IOs of the '20s, but not so. They are more risky.

Limiting the interest-only period to 10 years means little because few borrowers these days have their mortgages for 10 years. Most will refinance or sell their homes while they are still in the interest-only period.

[Selling quickly for capital gain, and refinancing to "put equity to work," reflects a new mantra: You grow equity through property appreciation, not by paying down your loan balance. The mantra ignores the fact that mortgage amortization is in the homeowner's control while appreciation is not.]

Risky change: now they're adjustable, too
But the big change in the risk of IOs, relative to the '20s version, is their attachment to adjustable-rate mortgages, or ARMs. ARMs are risky in themselves because borrowers are exposed to rising mortgage rates when market rates increase. Adding an interest-only feature heightens the risk. When the ARM rate is adjusted sometime in the future, the new payment is calculated using the original loan amount, as opposed to the smaller balance on a fully amortizing ARM.

Consider, for example, an ARM with an interest-only payment option for 10 years and an initial rate of 4 percent, which resets every six months. In a worst case scenario, the rate would ratchet up by 2 percent every six months and reach a maximum of 10 percent in month 19. The interest-only payment in that month would be 150 percent higher than the initial payment. The fully amortizing payment, in contrast, would be only 82 percent higher.

Gimmickry, misdirection, misperception
The attachment of the interest-only to adjustable-rate mortgages also explains the rapid growth in interest-only popularity. Adding an interest-only period to ARMs opened the door to a variety of merchandising gimmicks based on an ingenious piece of misdirection: IOs are presented as a new type of mortgage, with lower rates than standard fixed-rate mortgages.

Of course, rates on IOs are lower because the IOs being touted are ARMs, not because of the interest-only option. Indeed, because the interest-only option increases default risk, the option added to any given type of mortgage increases its price. Bankrate's surveys, for example, find that the average rate for a 5/1 interest-only ARM is consistently higher than a regular, fully amortizing 5/1 ARM. But most borrowers don't understand this because they don't understand ARMs, so for the most part the misdirection is marvelously effective. I didn't anticipate this, which is why my initial judgment, that IO was a flash in the pan, was so far off the mark. Some large lenders report that IOs account for 40 percent or more of their production.