When interest-only mortgages make sense

Interest-only mortgages may have contributed to the real estate collapse in 2008, but these mortgages are making a comeback because of the flexibility they provide for the cash-strapped home-buyer.

Should I refinance into an interest-only mortgage?

Just a few years ago, the idea would have seemed preposterous. After all, interest-only mortgages were a key factor in the real estate collapse that preceded the Great Recession. The mortgage industry enabled people to buy homes with minimal down payments, minimal credit score requirements and super-low initial monthly payments. When interest rates reset to a much higher rate after a few years, many homeowners found themselves unable to afford the new payments. The Consumer Financial Protection Bureau has noted many borrowers simply didn’t understand the risks associated with this type of loan.

For a while, interest-only loans largely went away, but lately there’s been renewed interest in the product. Many lenders are offering these loans, although now they are requiring borrowers to have sizable down payments, exceptional credit scores, and proof that buyers can make the higher payments after the initial rate period ends. The result is that interest-only loans may be worth considering in some situations.

If you are a borrower considering an interest-only mortgage, whether for a refinance or an initial loan, it’s critically important to weigh the significant risks and drawbacks against possible benefits for your situation.

How it differs from conventional loans

If you’re a first-time homebuyer, or have only ever pursued fixed-rate mortgages, here’s a brief summary of interest-only loans:

With a conventional 30-year mortgage, you take out a loan at a fixed mortgage interest rate, and for the next 30 years you make a fixed monthly payment that is part principal, part interest. When you make that last payment 30 years later, you are done.

In contrast, in an interest-only mortgage, for the initial period — say, 10 years — you again have a uniform monthly payment. But with this mortgage, your monthly payment goes only toward paying down the interest on the loan, not the principal. At the end of 10 years, the interest rate resets to a variable rate. And then for the next 20 years you pay a variable payment of interest (yes, another round of interest) and all of the principal. Not surprisingly, monthly payments get a lot bigger.

Keep in mind that an interest-only loan is not the same as an adjustable-rate mortgage, which has variable interest rates from the beginning of the loan. The monthly payment on these loans goes toward paying down both interest and principal.

The appeal of interest-only loans is simple: They are cheap, at least for the introductory period. The initial fixed interest rate is lower than one on a conventional 30-year mortgage, and when you combine that with the fact that you have a 10-year moratorium on paying the principal, you can imagine how attractive those first 120 monthly payments are.

Typically people assume that in that initial 10-year period they can bank the savings, grow their salaries so they can afford the higher payments down the road, and simply refinance into a more favorable loan before the balloon payments start.

Potential downsides

Unfortunately, things don’t always work out that way. It can be difficult for many people to bank savings, whether because of job loss or other factors, and not everyone will see a skyrocketing salary. And while it’s easy to believe that mortgage rates will stay low for a long time, that’s not a given. I have a colleague with a convenient little blue book of mortgage rate tables from not too long ago that has been relegated to a shelf because at the time of print, it seemed too outlandish to model mortgage rates below 7%.

Remember, too, that if you are not paying principal, you are missing out on that slow but steady way to build equity. If the market drops, you can quickly find yourself underwater and unable to qualify for a refinance.

Also, any perceived advantages of an interest-only mortgage hinge on your ability to get out of it when it’s no longer advantageous to your financial situation. If you can’t refinance out of your interest-only mortgage when the rate resets to a higher one, you could face a hefty increase in your monthly payment. Will you be able to carry the higher payment? What if you are forced to sell your house? What if you are forced to sell it at a loss?

Case studies

Financial advisors tend not to look favorably on an investment that doesn’t grow your money. Still, some clients do make interest-only mortgages work for them.

Here are stories of three homeowners who are managing it well (all names are changed for privacy):

• April is a successful doctor who owns her own practice, and Ray is a teacher. They can afford a traditional mortgage based on their annual income and savings, but because April’s monthly income is variable, the mortgage payments were a strain on their cash flow. They refinanced into an interest-only loan because they can make the lower required payments even in tough months. And when cash flow is good, they pay extra and earmark it for the principal. Essentially, they are still making interest and principal payments, but on a schedule that fits their uneven cash flow.
• Mark and Maya are tech workers who are on their third interest-only refinance. They have good incomes, but part of their pay comes in the form of stock options. They want the short-term tax benefits of having an interest-only mortgage thanks to the federal mortgage interest deduction, the option to use bonuses and stock to pay down the mortgage principal aggressively, and the flexibility to make a lower mortgage payment should one of them lose a job or want to work in a lower-paying startup. They have built up equity quickly and are in a good position for their next refinance, which will be into a smaller traditional loan.
• Frank is a recently divorced dad. He wants to keep the family home for a few more years until his kids finish high school, when he will move back to Montana to be closer to his extended family. Because he plans to sell the home well before the interest-only period ends, and because cash flow is tighter now that he is divorced, an interest-only loan made sense.

In each of these cases, the homeowners are not taking on an interest-only loan because that is all they can afford. Instead, they are taking a calculated risk with a product that fits their situation. And, importantly, they are mitigating the risk of being unable to refinance or afford payments down the road, either by paying down principal or by planning to sell the home within a few years.

As with any financial investment, refinancing into an interest-only loan requires thought and research. Your financial advisor can be an important, objective third party to help you be sure that your eyes are wide open about the real risks and that you are appropriately weighing the potential pros and cons.

This article first appeared at NerdWallet.