by Barry Tadmore

Created on: April 15, 2008

Interest only mortgages are an interesting idea. If you don't have a lot of money and want to become a homeowner, it's a great way to save money if you don't have a lot of it to spend, and if that's the only way to get into a house, its a great option (as opposed to wasting money renting an apartment or house).

However, interest only mortgages are dangerous, for a number of reasons. If the interest rate goes up, the payments go up. It's that simple. Maybe you have a three-year ARM, but after three years, your payments could be higher than if you would've gotten a conventional 30-year amortized loan.

There are two main arguments I hear from the pro-interest-only people, who think that is the ONLY way to take out a loan. But I disagree with both arguments and believe it is the wrong decision 99% of the time.

First of all, many people argue that there are better ways to spend the extra money. "Why put the money into your mortgage when you can make it go to work for you?" Adding to their argument is the fact that an amortized loan doesn't pay down very well at all. Many people say that it is better to put your money into something that is "liquid" as opposed to putting it into your home loan. In order to get the money, you need to take out a loan against your home, which is expensive. But if you can afford the extra payments to be on an amortized loan, why not put the money away where you can't touch it? It is guaranteed savings for down the road, where you might need it in case of an emergency. You should be able to save a few extra bucks each month to put into savings, and that should be good enough for you if anything minor comes up.

Secondly, the interest-only enthusiasts say that homes appreciate so much that you don't need to pay down the loan for it to be a good investment. I've never really understood that argument. If you sell your home, you're probably looking to buy a new home, right? So you're selling your home that has appreciated, let's say 20% over the three or four years you've owned it. But you're also buying a home that has appreciated 20% or so. When you sell your home, you will not have as much equity to spend on your new home, so you have to take out a bigger mortgage, interest-only or not, and the payments will be higher. But if you've continued to pay your loan down on an amortized schedule. You'll have that much more equity and that much more money in your pocket when you sell.

In the end, the variable interest rate of an interest only loan is the biggest reason not to take this type of loan. Interest rates fluctuate and you'll never know how high the rate or, more importantly, the payment will go. Fixed rate conventional loans will continue to be the most popular loans because they make sense!

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