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.

Hooking borrowers on the notion that IOs are a new type of mortgage with lower rates sets them up for several derivative misperceptions.

Faster paydown myth

One of the most common is that if a borrower makes a mortgage payment larger than the interest-only payment, the IO will amortize faster than “other mortgages.” You do get this result if you compare the amortization on an interest-only ARM with that on a fixed-rate mortgage carrying a higher rate, and you assume that the ARM rate doesn’t change during the period you are looking at. But borrowers are led to believe that this comparison is between IO and non-IO, when in fact it is between an adjustable and a fixed-rate mortgage.

On any given type of loan, whether fixed or adjustable, the same payment will amortize the interest-only version, and the otherwise identical non-IO version, in exactly the same way. But if the rate on the interest-only version is higher, which is almost always the case, it will amortize less rapidly than the non-IO version.

Borrowers also confuse the interest-only period with the initial-rate period of the ARM to which the IO is attached. My impression is that loan officers don’t misinform them about this, but they don’t bother to correct them either.

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