On Personal Finance | A mortgage that puts interest first

By Jeff Brown
Inquirer Columnist
Philly.com

Sunday's column on mortgages looked at the pros and cons, given today's interest rates, of the most widely used loans, such as fixed-rate ones and adjustables.

But what about the lesser-known types? Here's a look at one: the interest-only mortgage. To back up for a second, the monthly payment on an ordinary mortgage has two main components. One is principal, which pays back a portion of the money you borrowed. The other is interest - a payment for the use of the lender's money. With an interest-only mortgage, the payment covers just the interest. You pay the principal later.

Since the monthly payment does not include principal, it's lower than it would be on a conventional loan of the same size. A borrower can save some cash or qualify for a larger loan. But over the long term, the interest-only borrower pays more. Here's why:

Standard fixed-rate mortgages are "amortized" over a given number of years so that the monthly payment is always the same. It's as if the remaining loan balance is multiplied by the interest rate each year to determine the interest owed that year.

During the first year, when the outstanding principal is very large, the lion's share of each month's payment is for interest. Over the years, principal gets smaller. The interest payment therefore gets smaller, too, and an ever-larger portion of the fixed monthly payment goes to principal.

In the final year, with just a small principal remaining, everything's reversed: Virtually all of the payment is for principal; just a tad, for interest.

With an interest-only loan, the principal doesn't get smaller. So it's like making the first month's payment over and over again. (For what follows, my thanks to HSH Associates, the Pompton Plains, N.J., mortgage-data firm.)

On a $100,000 loan for 30 years at 6 percent, the monthly payment on a conventional mortgage would be $600 - $500 in interest, $100 in principal. With an interest-only loan, you'd pay just the $500 in interest.

Although this sounds good, the interest-only deal will cost more in the long run. With one type, for example, you pay only interest for the first 15 years, then interest and principal for the next 15. In every month, the remaining principal is larger than it would be with a standard loan, so the interest payment is bigger.

Total interest with a $100,000 conventional fixed-rate loan at 6 percent for 30 years would be about $116,000. Use an interest-only loan with the same rate but no principal payment for 15 years, and total interest would come to $142,000.

With the interest-only loan, the borrower pays $100 a month less for the first 15 years - $500 a month instead of $600. But in the final 15 years, she pays $844 a month due to the large debt remaining. Because the principal is high, interest payments are high. And the principal has to be paid off in 15 years instead of 30, so monthly principal payments are bigger than with a conventional loan. Why would anyone get an interest-only loan if it would cost more in the long run? As I said, some are drawn by the prospect of qualifying for bigger loans. Some have other uses for that $100 a month. And others - gamblers and folks with sophisticated approaches to finances - see investment opportunities.

Suppose you got the interest-only loan and invested the $100 you'd save during each of the first 180 months. At an 8 percent annual return, that would grow to $34,600 in 15 years. With a good enough investment return, this fund could more than offset the high monthly payments in the final 15 years - you'd earn a profit.

A real pro would also consider inflation and other factors, figuring that every dollar saved now might be worth more than two or three inflation-ravaged dollars spent in the distant future.

But unless you know how to do those sophisticated financial calculations, best steer clear of interest-only deals.

For most of us, they're too hot to handle.