Could you handle an interest-only loan?

By Liz Pulliam Weston

How would you like a mortgage that either significantly lowered your monthly payment or allowed you to buy a lot more house?

An interest-only mortgage can do either, and lenders increasingly are touting them as the answer to many borrowers' prayers. Whether these loans turn out to be a blessing or a curse, though, depends a lot on who's doing the borrowing:

• If you're a disciplined investor, good with money, a bit of a risk-taker and not buying more house than you can handle, an interest-only mortgage could work for you.

• If you're not all of those things, you probably want to stick to a more plain-vanilla mortgage.

"It's a bad idea for someone who can barely afford the house they're buying," said Brad Blackwell, national sales manager for Wells Fargo's West Coast mortgage operations. "If you're using the extra money to put food on the table, it's better to get a (more conventional) loan."

The catch

Most mortgages require that you pay back some principal with each payment -- a little bit at first, a lot more as time passes. Interest-only loans skip that requirement in the early years of the loan so that none of your payment goes toward paying down principal. The result is a significantly smaller initial payment compared with other options, such as a 30-year fixed-rate mortgage or a hybrid loan whose rate is fixed for the first five years:

How payments differ on a $500,000 mortgage
Mortgage type	Rate	Payment
Five-year interest-only	3.88%	$1,615
Five-year hybrid	3.75%	$2,316*
30-year fixed	5.75%	$2,918

* Assumes loan is amortized over 30 years, but rate is fixed only for the first five years.

Like regular mortgages, interest-only loans come in many different forms. The rate can adjust annually or be fixed for a while (usually five, seven or 10 years) before becoming variable. The interest-only portion may end after the fixed period, or it may continue for a few more years before principal payments are required. As with other adjustable-rate mortgages, there are typically caps that determine how much your interest rate can rise each year and during the life of the loan.

Here's how it might work for a five-year, interest-only loan:

• Your payments would be fixed for the first five years at a certain interest rate -- say, 3.875%.

• For the next five years, you still might pay just interest on the loan, but the rate would be variable and could increase by two percentage points every six months, up to a cap of 9.875%.

• In the 11th year, the rate remains variable, but the loan requires you make both principal and interest payments.

Nobody can accurately predict future interest rates. But this is an example of what you might pay on a $500,000 mortgage if the rate started at 3.875% and jumped three percentage points in the sixth and eighth years:

How payments can change on an interest-only loan
Years	Rate	Monthly payment
1 to 5	3.88%	$1,615*
6 to 8	6.88%	$2,864*
8 to 10	9.88%	$4,114*
10 to 30	9.88%	$4,783**

* Interest only **Includes amortization of principal over 20 years.

As you can see, the monthly cost can climb steeply, especially once you start paying back principal. You could end up paying a lot more each month than if you had stuck with a 30-year, fixed-rate loan.

Not a long-term proposition

Interest-only loans make the most sense when you're borrowing a big chunk of money. At smaller loan amounts, the savings might not offset the loans' greater risk.

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