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They’re spreading like wildfire–interest-only mortgages appear to be the panacea for rising home prices and the incomes that cant quite catch up. You can buy “more house” and have a low mortgage payment and a big tax deduction. Who wouldnt want one, right?

Well, a large number of consumers are getting into these loans when they shouldnt. Interest-only mortgages work well for some individuals and are dangerous for most others, yet the number of interest-only loans is rising rapidly.

Take a look at San Diego. In 2004 almost half of the mortgages required interest-only payments in the first few years according to a study done by LoanPerformance, a San Francisco–based real estate information service. Could this have something to do with the housing market? You bet it does. Are home prices rising faster than salaries and incomes? They sure are. So how is one supposed to afford a house in such an expensive housing market? You guessed it–an interest-only loan.

Interest only-loans were originally aimed at more sophisticated investors who wanted to leverage their income by re-directing what would have been the principal portion of their payment to higher yielding investments that exceed the rate of their home appreciation. These types of investors typically have more assets and financial discipline than most and therefore aren’t as likely to get in as much trouble with such a loan.

Today, interest-only loans are being utilized by borrowers who are trying to leverage debt. What they are doing is getting more debt for their buck; they’re borrowing more money but keeping their payments low (initially) in order to compete with other buyers in sellers markets. Here are some of the potential dangers that face such borrowers:

If the principal balance isn’t being reduced, than no equity is being built, and if home prices are stagnant during the interest-only period and the borrower needs to sell, he’ll need to be able to pay sales costs out of whatever equity there is in the house, if there is any. Remember, mortgage amortization is in the borrowers control, appreciation is not.

If theres a downturn in home prices, the borrower could end up upside down, meaning the mortgage balance on the property could end up being greater than the propertys market value. In this case, the borrower would be responsible for sales costs and the remaining mortgage balance which could lead to foreclosure.

Interest-only mortgages make sense for borrowers:

who have seasonal incomes or earn commissions and/or bonuses and have a desire to pay on the principal when its convenient.

upwardly mobile individuals who expect to earn more in a few years and want to buy more house early on rather than later.

who intend on investing their cash flow in higher yielding investments or paying down high-priced debt.

Make sure you know what youre getting into with an interest-only loan. Consult with your mortgage broker or lender to know what the possible repercussions could be, and be sure youre getting the loan for the right reasons. Eventually, you want to own your home, and its better to be planning on that sooner than later.

Too good to be true? It probably is. The Adjustable Rate Mortgages (or ARM in industry lingo). These guys can be a wolf dressed in sheep’s clothing and if you aren’t careful they are going to take your home away from you!

An Adjustable Rate Mortgage works this way. Initially, you are probably going to be paying anywhere from 2 – 3 % below the current market interest rates on your mortage. For most people, this allows them to purchase a bigger house, one that would normally be outside their price range. The normal reasoning is that by the time the loan adjusts they will be earning more, the economy will be better, etc.- which could be a year from now, or as much as 7 – 10 years from now –

Sometimes it just isn’t that way. In no time, we went from two incomes to one or we just aren’t making as much as we were. Worse still, interest rates rise and when it comes time for our ARM to adjust it goes up.

Some Adjustable Rate Mortgages changes every year based off current interest rates set by the Federal Reserve. Sometimes, this can be a good as interest rates may have fallen and you could end up paying in interest than you were at the start of your loan.

There are other ARM’s that adjust after a number of years – say 7 to 10. When they finally commit themselves, it can be a real sticker shock for the homeowner. If they haven’t planned for this financially it could mean the difference between them keeping or losing their home because monthly mortgage payments could double in size depending on how low your interest rate was before the adjustment and what current interest rates are.

So what’s the best decision that most smart home owners make? Go with conventional mortgages that have a predefined interest rate that is locked in over the life of the loan. If market conditions allow, you can always look into refinancing your mortgage and getting a lower interest rate.
Adjustable rate mortgages are good for those who like to take risks – and some argue they are good for families just starting out who know they will need a bigger house in the future and will have larger incomes in the future as well. However, as we all know, nothing is as certain in life as change and sometimes the smart homeowner knows when to play it safe and keep a roof over his or her head!