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Posted On: 07/21/2010

QUESTION:

During the past few years, interest-only loans were popular. Are they still available?

ANSWER:

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In theory, yes. In practice, well, er, read below.

An interest-only mortgage is a form of financing where the borrower pays only interest during the start period, say the first five to 10 years of the mortgage. The borrower has a lower monthly payment because the debt is not being reduced. However, once the start period ends the monthly cost can rise significantly.

Here's an example. A $300,000 fixed-rate mortgage at 5 percent over 30 years has a monthly cost for principal and interest of $1,610.46. On an interest-only basis, the monthly cost would be $1,250. If there's a 10-year start period, then at the start of year 11 - if the interest rate remains 5 percent - the new monthly payment will be $1,979.87. For a five-year start period, the new payment would be $1,753.77.

Is the future higher payment really a problem? After all, hasn't the borrower's income increased over a decade?

Indeed, borrower income may have increased - but not enough. For instance, imagine if the interest rate rises to 7 percent - a low rate by the standards of the past 50 years. Now the monthly payment would be $2,120.34 after five years and $2,325.90 after a decade. That's a big difference when compared with $1,250. In addition, costs for insurance and property taxes also are likely to have risen.

Because interest-only loans represent long-term risk, Fannie Mae now says it will buy interest-only mortgages from local lenders, but only if the borrower puts down 30 percent, has a two-year financial reserve and a 720 credit score.

So, yes, you can still get an interest-only loan. But why bother? There are now so many barriers to such financing that interest-only loans make little sense. If you've got reserves for two full years of mortgage payments then surely you can afford a self-amortizing mortgage.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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