Who should get an interest-only mortgage?

At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here’s an explanation for

Interest-only mortgages are pushed aggressively nowadays by lenders and brokers, but they’re not for everyone.

An interest-only mortgage might be a good fit for:

  • someone whose income is mostly in the form of infrequent commissions or bonuses;
  • someone who expects to earn a lot more in a few years;
  • someone who truly will invest the savings on the difference between an interest-only mortgage and an amortizing mortgage, and who is confident that the investments will make money.

Financial advisers don’t recommend interest-only mortgages to regular wage earners who take out moderate-size home loans and don‘t have a strategy for investing the savings.

With an interest-only mortgage loan, you pay only the interest on the mortgage in monthly payments for a fixed term. After the end of that term, usually five to seven years, you either refinance, pay the balance in a lump sum, or start paying off the principal, in which case the payments jump skyward.

If there were such an animal as a typical interest-only borrower, it would be an executive who earns a moderate salary and whose main income is from bonuses once or twice a year, says Jim McFadden, program manager for private mortgage banking for Wells Fargo. An interest-only mortgage would provide the lowest possible monthly payment for lean months, yet allow the executive to pay down big chunks of principal when bonus time rolls around.

Business owners with unpredictable incomes might benefit from interest-only mortgages, too, because “they need to maximize their cash flows as much as possible, and this is a great way of doing it,” McFadden says. “And, of course, you have the option of paying down principal whenever you want.”

Historically, interest-only mortgages were for affluent borrowers, he says, but “you’ve seen the product come down-market a little bit in the last couple of years.”

When you go too far down-market, interest-only loans don’t save enough money to be worthwhile. Let’s say you borrowed $200,000 at 7 percent. For the first three years, the savings from an interest-only loan would amount to less than $200 each month. Double the loan amount to $400,000 at 7 percent, and an interest-only loan saves more than $325 in the first month.

Online lender E-Loan began offering interest-only mortgages this year because they provide borrowers with a lot of flexibility, E-Loan co-founder and CEO Chris Larsen says. They’re available in typical-size loans — even for under $200,000. The power of an interest-only loan kicks in, Larsen says, because “you can buy much more house.”

The inference is that an interest-only mortgage allows one to buy more house than one can afford. That’s not what Larsen means. He says these loans appeal to people on the career fast track, “younger borrowers who have a future of increased earnings ahead of them … and really want to maximize their buying power now.”

— Updated: Oct. 20, 2004

J. David Lewis, a certified financial planner with Resource Advisory Services in Knoxville, Tenn., generally frowns upon interest-only mortgages. He says they might be legitimate for fast-trackers who need to present an upscale image for career success.

“I can see, having dealt with a few executives, that it’s important sometimes to have a home that you can do entertainment in,” Lewis says. “I can’t see the average guy doing an interest-only mortgage because I can see him digging himself into a big trap.”

Among the traps are the risks that the house will lose value and that the borrower will lose a job.

Mortgage bankers McFadden and Larsen say interest-only mortgages benefit borrowers who invest the money they would have paid as equity. They come out ahead if their investment returns exceed the rate of home appreciation.

“For someone who says, ‘It would be better to put my assets into a stock portfolio or college education for my kids,’ the interest-only gives you that flexibility,” Larsen says. This idea fits in with Larsen’s philosophy that middle-class people should have the tools to manage their debts as carefully as they manage their assets.

Tom Muldowney, a certified financial planner with Savant Capital Management in Rockford, Ill., says he has a 75-year-old client with a $45,000 mortgage. She could pay it off with a check if she wanted to. But she has a 4.75 percent interest-only loan, and the interest is tax-deductible — and she’s in the 38.6 percent bracket. With the tax deductibility, she’s borrowing at an effective rate of less than 3 percent. It’s a slam dunk to earn more than that with a well-diversified investment portfolio, so, McFadden asks, why pay off the loan?

The conservative Lewis agrees that such reasoning is impeccable. “The math always works out,” he says. But, he adds, decisions about investing and spending are guided not only by math, but by psychology.

Lots of people tell themselves that they’ll invest the difference between interest-only and amortizing mortgages, Lewis says, but not all of them follow through. The money is there, tempting them to spend it on boats, vacations, pampered lifestyles.

“The people who are frugal about going into debt, or don’t use much debt, are generally the ones with higher net worth,” he says. “It’s just that somehow in their life, they accumulate more wealth.”

— Updated: Oct. 20, 2004