Posted on: Thursday, June 2, 2005

THE COLOR OF MONEY
Interest-only home loan tempting, but tread cautiously

By Michelle Singletary

In the movie "Field of Dreams," an Iowa corn farmer kept hearing whispers of "if you build it, they will come."

I think of that famous line when I see advertising for interest-only loans. All the financial institutions have to do is build a loan product and people will come — even when they shouldn't.

Interest-only loans are just that — at first, you pay only the interest on what you borrow. An interest-only payment option can come with a 30-year fixed loan or an adjustable-rate mortgage. The length of the interest-only loan can vary from three years to 10 years.

The rates on interest-only loans can change as often as every month or be fixed for periods of three years to 10 years.

Without a doubt, an interest-only loan has a great selling point — you can qualify for a higher-priced home.

Let's say that under a traditional mortgage product where you pay interest and principal, you would qualify for only a $250,000 loan. With a 30-year mortgage at 5.72 percent, your payment would be $1,454 excluding taxes and mortgage insurance. But with a five-year interest-only ARM at 4.68 percent, you could get a $350,000 mortgage and your monthly payment would be $1,365.

In heated real estate markets, people fear that if they wait to buy, homeownership will escape them. That's one reason interest-only loans have become extremely popular.

Here's how one lender advertised interest-only loans: "You won't build equity in your home during the interest-only period, but it could help you afford to buy the home you want instead of settling for the home you can afford."

But ask yourself if it is worth it to buy a home that could put you in the poor house.

"Interest-only loans, while a wonderful product, need to be used judiciously," said Morris Armstrong of Armstrong Financial Strategies, a fee-only planning and asset management company based in Danbury, Conn.

"Because they allow you to effectively borrow more money than under a conventional loan, they can create situations where the borrower is in over their heads, which can lead to financial difficulties including foreclosure."

So when might an interest-only loan be good for you?

• If you don't expect to stay in your home long, say five to seven years. For example, an interest-only loan might make sense for single people with the hopes that they will get married, move up, or relocate for a job, said Colleen Sargent, owner of F&M Mortgage Corp. in Fairfax Station, Va.

• If you're in an upper-income tax bracket and want to deduct the highest possible amount of home interest.

• If you expect a large expense to go down or your income to go up significantly. "Imagine if you are paying $12,000 a year for childcare and that in three years those payments will cease," Armstrong said.

There's another group of home buyers who are opting for interest-only loans — people looking for the lowest mortgage payment possible and probably wouldn't qualify for the house they want with a loan payment that included the interest and principal.

It's that last group that worries me the most — home buyers who are just barely squeezing into a house with an interest-only loan.

"I am not sure that any loan which enables someone to dig their financial grave is good and I wish that underwriters would realize that," Armstrong said.

What happens the day when you must make interest and principal payments?

Borrowers with interest-only loans that convert to a variable rate after the fixed term is over need to be particularly careful, especially if interest rates rise, cautioned James R. Cotto, director of investments at Cotto & Padovani Financial Strategies Group in Mount Kisco, N.Y.

Make sure you fully understand the pros and cons of an interest-only loan.