Interest-Only Mortgages Are Back ... Should We Be Afraid?

Even if you don’t know much about home loans, you’ve probably heard of interest-only mortgages, if only because they played a large role in the financial crisis of 2008 and 2009. These loans practically disappeared during the recession but have since started to make a comeback, but that’s not necessarily something to be concerned about. Interest-only mortgages are a risky product with a bad reputation, and the loans available now aren’t like the ones that made a mess of the economy several years ago.

What Is an Interest-Only Mortgage?

With a traditional 30-year fixed-rate mortgage, your monthly payments go toward both the principal balance and the interest accrued on the loan. An interest-only mortgage has a period — commonly 3, 5, 7 or 10 years — during which you’re only paying the interest accrued on that principal. If you take out a $100,000 loan and make payments on the interest accrued for 10 years, you’ll still have $100,000 to repay (plus interest) over the next 20 years of the loan. Instead of spreading that $100,000 over 30 years, you now have to pay it over 20, resulting in higher loan payments (the interest rate also resets at the end of that first period, meaning your interest rate could go up).

Loose underwriting standards allowed consumers with little to contribute to a down payment and less-than-great credit scores obtain interest-only mortgages before the financial crisis, said Scott Sheldon, a senior loan officer in Santa Rosa, Calif. “People tried to squeeze into a house they couldn’t afford, because they could only afford the interest-only payment,” he explained.

Historically, homeowners relied on the ability to refinance their homes at the end of the interest-only period said Tony Sachs, chief lending officer of online mortgage marketplace Sindeo. Home values tanked during the crisis, wiping out home equity and the option to refinance, so when borrowers’ payments increased, they couldn’t afford them and started defaulting on their loans.

Who Can Get an Interest-Only Mortgage?

Interest-only loans aren’t meant to be an affordability tool, Sheldon said. As the economy has improved, lenders started offering them again (within the past year or so), but they’re much different than those pre-2007 loans that everyone associates with the term “interest-only.”

“They’re usually geared toward higher-net-worth individuals who are interested primarily in cash flow and otherwise have a lot of assets,” Sheldon said. The interest-only loans he can originate now have stringent requirements: “We usually want 12 months of mortgage payments in the bank, in addition to the 740 credit score, in addition to the 25% down payment.”

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He said they’re only available for jumbo loans right now (loans that exceed the limits set by Freddie Mac and Fannie Mae), so it’s not the sort of thing the average consumer would be looking at.

“They are meant for people who have … the appetite for risk and have the ability to absorb the consequences, should they be negative,” Sachs said. “For the right person, they can be used as a successful mortgage product and financial or tax-management tool.”

For example, someone who is well-paid but receives large bonuses may want an interest-only loan, to preserve their take-home pay throughout the year and make large, voluntary contributions toward the principal when they receive their bonuses. It’s an alternative to paying more throughout the year with a loan amortized over 30 years. Another type of person who may want an interest-only loan is someone who could afford to pay cash for a property but uses the interest-only mortgage to claim the mortgage interest tax deduction.

It depends on the lender, but you’ll generally need a great credit score, a large down payment and a low debt-to-income ratio to qualify for one of these loans. Actually, those qualifications are great to have no matter what kind of home loan you want, and by checking your credit score regularly, you can make a plan to get it ready for mortgage underwriting, when you’re thinking of buying a house. You can get your credit scores for free every 30 days on Credit.com. You more than likely won’t be going after an interest-only mortgage any time soon, but it’s still important to go into the home loan process with the best financial situation you can muster.

Based on the tight lending standards for interest-only loans and the regulations that came after the mortgage crisis, it doesn’t seem like there’s a need to be concerned about this product’s resurgence.

“They are becoming more prominent because the economy is improving, the housing market is improving,” Sachs said. “They are being done in a more responsible way.”