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Interest-only mortgages gain popularity, but consumers should be cautious

Posted: Friday, July 23, 2004

NEW YORK (AP) As interest rates have risen, some families are looking for ways to hold down the cost of buying a home. One increasingly popular approach is the interest-only mortgage.

With traditional mortgages, the monthly payment consists of an interest portion and a principal portion; over time, the amount going to interest decreases and the amount to principal increases until the loan is paid in full. With an interest-only mortgage, borrowers pay only interest in the early years of the loan; later on, principal payments kick in, too, but at a higher level than with a traditional mortgage because they're paid over a shorter period of time.

Proponents of interest-only mortgages say they're a boon to families who need lower monthly payments to qualify for a mortgage. But consumer experts warn that this could entice families to commit to more than they can afford in the long run.

Take the classic case of a young couple buying their first home, said financial counselor Eric Tyson, co-author of ''Mortgages for Dummies.''

''An interest-only mortgage gives them a low payment that may be all they can afford at the beginning,'' he said. ''But say five or seven years down the road, when the payment jumps up, maybe one of them isn't working anymore because they have a baby. In that case, a higher payment isn't going to work well.''

Still, there are a number of advantages to interest-only mortgages, said Bob Walters, chief economist at Quicken Loans, which is based in Livonia, Mich.

Lower monthly payments ''mean that family can probably afford a bit more home, and in California or on the East Coast where prices have risen dramatically, this can mean the difference between getting a home or not,'' he said.

Walters gave this price scenario for a family that needs a $200,000 mortgage:

With a traditional, 30-year mortgage carrying a 6.25 percent interest rate, a family would have to pay $1,232 each month in principal and interest for the duration of the loan.

An interest-only mortgage probably would carry a slightly lower rate at the beginning, say 5.875 percent, and monthly payments for the first five years would be $979, covering only the interest due. After that, the rate likely will be raised, say to 6.875 percent, and both interest and principal will be due, requiring a monthly payment of $1,397.

A variety of interest-only loans are available, some of which adjust every time a bank's prime lending rate changes. Others have fixed rates for three, five, seven or 10 years before they're adjusted.

One concern about these mortgages is that families are not building equity in their homes in the early years because they are not making any principal payments.

Walters counters that even with a traditional mortgage, most of the money in early payments goes to interest ''so most peoples' equity comes from appreciation, not principal payments.''

Walters also said consumers who take interest-only mortgages can use the money they save on their early payments for other purposes, such as buying home furnishings or paying down credit card debt or funding retirement accounts.

''That may be a better use of those dollars,'' he said.

It was the cash flow advantages that attracted Don Weidenfeld of Delray Beach, Fla., to an interest-only mortgage.

Weidenfeld, a 38-year-old bond trader, took a 20-year interest-only mortgage when he refinanced recently. It started at 3.75 percent interest and rises with the prime rate. It's currently at 4 percent, and he expects it to go to 4.25 percent after the Federal Reserve raises interest rates again.

Even with the increases, paying only interest ''has reduced my monthly payment significantly,'' Weidenfeld said.

He used some of the savings to buy a boat. But he said he could also take that money and apply it at the end of the year to his principal, reducing the size of his $120,000 mortgage.

''It really acts more like a home equity loan,'' he said. ''It gives you flexibility.''

Tyson, the financial counselor, said families especially first-time home buyers should research interest-only mortgages carefully.

Some of these mortgages are actually balloon loans, requiring payment in full when the interest-only term ends, he said. That could force a family to refinance at a time interest rates are less favorable than they are now.

Tyson also said families should make sure they understand exactly when and how the monthly payment adjusts.

''It comes down to being an informed consumer,'' he said. ''There's nothing wrong with taking one of these things if you know what's going to happen to your payment in the future and you do some planning for it.''



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