Interest-only mortgage deja vu

On many ARMs, the initial rate holds for a year or less, so that the ARM rate is adjusted within the interest-only period. Borrowers who take interest-only loans thinking that their rate was safe for 10 years face a rude awakening.

Lest you get the impression that I am opposed to interest-only loans, not so. What I am opposed to is the merchandising of IOs as if they are a new type of mortgage with magical qualities. Interest-only is an option that can be attached to any mortgage, and it should be marketed as an option. Options can be useful if they meet special consumer needs, which the interest-only option does.

Interest-only mortgages are worthwhile when borrowers:

• Pay principal when convenient. Borrowers with fluctuating incomes may value the flexibility the interest-only mortgage gives them. When their finances are tight, they can make the interest-only payment, and when they are flush they can make a substantial payment to principal.

Tip: Ask yourself whether you are disciplined enough to make the payment to principal when you aren't obligated to.

• Use substantial extra payments to reduce the monthly payment. On most IOs, an extra payment will reduce the required monthly payment the following month. This is a nice feature for borrowers who anticipate a windfall that they want to use to reduce their monthly payment. On a standard fixed-rate mortgage, extra payments don't affect the required monthly payment, and on ARMs, this does not happen until the next rate-adjustment date.

Tip: On some IOs, the payment doesn't adjust for a year, and on others it doesn't adjust until the end of the interest-only period. ASK!

• Buy more house by anticipating income growth. It is common for families to begin with a "starter house," then move into more-expensive houses as their incomes rise. This process of "trading up" carries high transaction and moving costs that can be avoided by passing on a starter home and buying a larger house now. In the short term, this will cause a cash-flow strain, but the interest-only mortgage may make it manageable.

Tip: Ask yourself whether you are comfortable with the risk that the expected higher income won't materialize.

• Invest the cash flow. For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the after-tax mortgage rate, since that rate is what they earn when they repay their mortgage.
  
  A valid example is the young borrower with a longtime horizon who invests in a diversified portfolio of common stock. This should generate a yield of 9 percent or more over a long period. Another example is the business owner who might earn a high return investing in the business.

Tip: Ask yourself whether you really will invest the excess cash flow, as opposed to spending it, and whether you have a firm basis for believing that your investments will yield a return higher than the mortgage rate.

• Pay down high-priced debt. Borrowers who have other debt at high interest rates might rationally select an interest-only option on their first mortgage so they can accelerate repayment of the more-costly debt. If the rate is 5 percent on the first mortgage and 8 percent on the second, it makes sense to allocate as much as possible to repayment of the second.

Tip: Ask yourself whether you have the discipline to use the cash flow savings on your first mortgage to pay down other debt.

• Make a quick score on a fast turnover: An interest-only loan is useful in a quick turnover situation only if you are trying to maximize the amount of house you can buy, and are limited by your income. The interest-only option lowers the required initial payment, which allows you to qualify for a larger loan amount.
  
  Your objective in a quick-turnover situation should be to minimize your total net costs over the short period you have the mortgage, and the IO doesn't affect the cost. The payment is lower with the IO, but balance reduction, which is a cost offset, is eliminated.
  
  To minimize total net cost over a short period, focus on finding the best combination of interest rate and rebate. A rebate is negative points, where the lender pays you for a higher rate instead of you paying the lender for a lower rate. A rebate will reduce or perhaps eliminate your upfront cost.
  
  When your time horizon is very short, paying a higher interest rate in exchange for a rebate is a good deal because you won't be paying the rate very long. Calculator 9ci on my Web site will allow you to determine the combination of interest rate and rebate that has the lower cost over the period you expect to have the mortgage.

My final tip: If you don't need an interest-only mortgage to qualify for the house you want to buy, it is not the best choice.

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at mtgprofessor.com