Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

The pros and cons of interest-only mortgages

Dear Dr. Don,
What is an interest-only mortgage loan? What are the pros and cons?
Mariet Mortgage

Dear Mariet,
The standard fixed-rate mortgage is an amortized loan. That means that the monthly payment includes both the interest expense on the outstanding loan balance and a principal component that reduces the outstanding balance.

The payment stays the same over the life of your loan, but over time the interest component shrinks as the principal component grows. Bankrate's mortgage calculator includes an amortization schedule so you can see how the two components change over time.

Interest-only loans can be structured in many different ways. They can be interest only for a set number of years and then have a balloon payment where you have to pay off the note, or they can convert to an amortized loan after an initial interest-only period.

Most interest-only mortgages are variable-rate loans, but you can set the initial interest rate for a period of years just like you would do with a 5/1, 7/1 or 10/1 adjustable-rate mortgage. Using a 10/1 interest-only loan, you'll have a constant payment amount over the first 10 years, but it's all interest. These loans are attractive if you're trying to stretch your budget to afford a bigger mortgage or if you don't plan to be in the house for long and don't care about building equity or paying down the note.

This type of mortgage is riskier for lenders because the homeowner isn't paying down the loan balance. The size of the down payment and the home's appreciation over time provides the buffer to protect the lender from losses should the house go to foreclosure. There's no question that you'll need private mortgage insurance if you can't meet the lender's loan-to-value standards, and you'll need to have a good credit history.

If you have the financial discipline to make additional principal payments on the loan during the interest-only period, you can wind up ahead of where you would be with a fixed-rate amortized loan. That's due primarily to the lower interest rate on the interest-only loan. This earlier column shows the math, while this Bankrate feature provides additional information on interest-only loans.

-- Posted: Oct. 7, 2002