Interest-Only Mortgage (Option)
Definition of "Interest-Only Mortgage (Option)"
An option attached to a mortgage, which allows the borrower to pay only the interest for some period. A mortgage is 'interest only' if the monthly mortgage payment does not include any repayment of principal. So long as the payment remains interest only, the loan balance remains unchanged. Interest-Only in the '20s and Now: If a loan is interest-only until maturity, the loan balance will be the same at maturity as it was at the outset. Back in the 1920s, loans of this type were the norm. Borrowers typically refinanced at term, which worked fine so long as the house didn't lose value and the borrower didn't lose his job. But the depression of the '30s caused a large proportion of these loans to go into foreclosure. Lenders stopped writing them and switched to fully amortizing loans. When interest-only loans were revived in this century, most were interest-only for a specified period, usually five to 10 years. At the end of that period, the payment was raised to the fully amortizing level. Purpose of Interest-Only (1): One purpose is to increase affordability by reducing mortgage payments in the early years. Purpose of Interest-Only (2): Another purpose of interest-only is to maximize investment leverage. A borrower earning 12% on investments wants to borrow as much at 6.25% as possible. Why pay down the mortgage to earn 6.25% when you can invest it to earn 12%? That seemed like a plausible policy during the late '90s when stock market returns were extremely high. In the more sober environment of 2002-2003, it didn't make sense for most borrowers. With the stock market in the tank and interest rates very low, mortgage loan repayment was the best investment available to most homeowners. Purpose of Interest-Only (3): Borrowers who have other debt at high interest rates might rationally select an interest-only option on their first mortgage so they can accelerate repayment of the more costly debt. If the rate is 5% on the first mortgage and 8% on the second, it makes sense to allocate as much as possible to repayment of the second. Interest-Only ARMs: The interest-only option on ARMs presents special problems. If the interest rate on an ARM increases, the payment increase is substantially larger if the payment is interest-only than if it is fully amortizing.
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