Can Interest-only Loans Work for You?

Here Are the Hidden Dangers

interest only loans allow this couple to buy their first house
Interest-only loans made homeownership more affordable. Unfortunately, many people didn't realize they weren't paying off the loan. Photo: Ariel Skelley/Getty Images

Definition: An interest-only loan is an adjustable-rate mortgage that allows the borrower to pay just the interest rate for the first few years. That's often a low "teaser" rate. The payment rises and falls with the LIBOR rate. LIBOR stands for the London Interbank Offering Rate. It's the rate banks charge each other for short-term loans. If LIBOR rises, so does the interest payment.

That "teaser rate" introductory period typically lasts one, three, or five years.

After that, the loan converts to a conventional mortgage. The interest rate may increase. The monthly payment must also cover some of the principal. That increases the payment a lot. Some interest-only loans require the borrower to pay off the entire balance after the introductory period (Source: "Interest-Only Mortgages," FDIC.)

3 Advantages

The first advantage is that the monthly payments on an interest-only mortgage are initially lower than a for a conventional loan. That allows borrowers to afford a more expensive home. That only works if the borrower plans to make the higher payments after the introductory period. For example, some increase their income before the intro period is up. Others plan to sell the home before the loan converts. The remaining borrowers refinance to a new interest-only loan. But that doesn't work if interest rates have risen.

The second advantage is that a borrower can pay off an interest-only mortgage faster than a conventional loan.

Extra payments go directly toward the principal in both loans. But, in an interest-only loan, the lower principal then generates a slightly lower payment each month. In a conventional loan, it reduces the principal, but the monthly payment remains the same. Borrowers can pay off the loan faster, but they don't realize the benefit until the end of the loan period.

An interest-only loan allows borrowers to realize the benefit immediately.

The third advantage is the flexibility an interest-only loan provides. For example, borrowers can use any extra money, such bonuses or raises, to apply towards the principal. That way, they don't notice a difference in their standard of living. If  they lose their jobs or have unexpected medical costs, they can go back to paying just the interest amount. That makes an interest-only loan superior to a conventional mortgage for disciplined money managers.

Disadvantages

First, interest-only loans are dangerous for borrowers who don't realize the loan will convert. They often cannot afford the higher payment when the "teaser rate" expires. Others may not realize they haven't got any equity in the home. If they sell it, they get nothing.

The second disadvantage occurs for those who are counting on a new job to afford the higher payment. When that doesn't materialize, or if the current job disappears, the higher amount is a disaster. Others may plan on refinancing. But if interest rates rise, they can't afford to refinance, either. 

The third risk is if housing prices fall. That hurts homeowners who plan to sell the house before the loan converts.

 In 2006, homeowners weren't able to sell, since the mortgage was worth more than the house. The bank would only offer a refinance on the new, lower equity value. Homeowners that couldn't afford the increased payment were forced to default on the mortgage. Interest-only loans were a big reason so many people lost their homes. 

Types

There were many types of exotic loans based on the interest-only model. Most of these were created after 2000, to feed the demand for subprime mortgages. That was because banks had started financing their loans with mortgage-backed securities. These derivatives became so popular they created huge demand for the underlying mortgage asset. For more about that, see What Really Caused the Subprime Mortgage Crisis?  Most of these exotic loans are no longer available. 

Also Known As: interest-only mortgage, exotic loans, exotic mortgages, subprime loan