Risk of an Interest-Only Mortgage

There are several different types of interest-only mortgages. The features of the loans vary but essentially all of the loans begin with a period of time during which the borrower does not have to make principal payments. These low payments appeal to investors or people planning on owning properties for a short period of time. However many homeowners with interest-only mortgages run into difficulties when the rate changes or the home's value changes.

1. Types of Interest-Only Loans

   • Adjustable-rate mortgages (ARM) have interest rates that adjust after a month, a year or after a period of several years. Many ARMs also begin with an interest-only period that last for between one and 10 years. After the interest-only phase, the borrower can either payoff the principal or allow it to amortize over the remainder of the 30-year term. Home equity lines of credit (HELOC) are revolving credit mortgage products that work like credit cards with interest only payments but unlike credit cards, HELOCs use residential property as collateral.

   Effect of Recession

   • During a severe recession, high unemployment often leads to reduced tax revenue and government deficits. Foreclosures stemming from unemployment can cause house prices to fall. The government raises funds to cover the shortfall by selling bonds. Investors demand higher than normal interest rates on the bonds because of the risk of lending to a government feeling the strain of a recession. ARM interest rates are based on government bond rates so ARM rates often rise during recession. However, due to falling house prices, people with interest-only ARMs lack the equity to refinance into a fixed-rate loan. They must contend with the rising payments or risk foreclosure.

   Effects of a Boom

   • The Federal Reserve Open Market Committee uses the federal funds rate to set the benchmark for interbank borrowing. When the economy experiences a boom it often leads to rapid inflation. To stem inflation, the FOMC raises the federal funds rate and in turn banks raise the prime rate that always remains 3 percent above the federal funds rate. HELOCs are tied to the prime rate and most have rate limits close to 20 percent, so monthly payments can rise drastically during a booming economy.

   Balloon Payments

   • Some interest-only mortgages end with a balloon payment at the end of a five- or 10-year initial interest-only term. Some people attempt to use the money they are not paying towards principal during the initial term to invest in the stock market. Theoretically a stock market boom could allow them to cash in their investments after the interest-only term and payoff the balloon and have surplus funds. However, one major political or economic event could cause the stock market to drop and leave the homeowner with no funds and a balloon they cannot afford to pay.