Home Owners Increasingly Betting on Interest-Only Loans

Some home buyers in hot real estate markets are using interest-only loans more and more. The loans are a practical financial tool for some, but a risky gamble for others.

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The interest rate on 30-year mortgages is inching up to a national average of more than 5 1/2 percent. That is still low by historical standards, but a growing number of home buyers are turning to other more exotic financing, trying to lower their monthly house payments. One alternative is the interest-only mortgage. These loans are getting more and more popular, but NPR's Scott Horsley reports they are not for everyone.

SCOTT HORSLEY reporting:

Mark Capabianco's(ph) old house was in a convenient neighborhood, where he could walk to shops and restaurants. But with just one bathroom, it was a little cramped. So last summer, he moved into a bigger house overlooking San Diego Bay.

Dr. MARK CAPABIANCO (Homeowner): I have a view and I like looking at the water, so that was the reason I moved. And plus I wanted a bigger place, so I wanted more space.

HORSLEY: Because the new house was more expensive, Capabianco took out an interest-only mortgage. That means he pays no principal for the first two years. He also got a significantly lower interest rate. Both those factors reduced his monthly mortgage payment.

Dr. CAPABIANCO: I don't recall exactly, but it's almost $2,000 a month savings.

HORSLEY: Capabianco is a doctor who consults for pharmaceutical companies. He's also a fairly savvy real estate investor. Most of the early users of interest-only loans were wealthy and sophisticated borrowers. Chief economist Doug Duncan of the Mortgage Bankers Association says the loans are now becoming more popular with middle-income home buyers, especially in markets like San Diego where home prices have risen rapidly.

Mr. DOUG DUNCAN (Mortgage Bankers Association): From our perspective, the loan instrument itself is sort of a morally neutral thing. It's a tool that it fits some households well and it fits others not well. So the question really is the fit to the household.

HORSLEY: Duncan says postponing principal payments might be a good idea for a family that expects to boost its income in a few years, if one spouse has been staying home with children, for example, and expects to return to work. But borrowers must be aware that those low initial mortgage payments will come to an end.

Mr. DUNCAN: Well, if you're a fixed-income household who's stretching to the max on your financial resources just to get into the house at the minimum interest payment, what are you going to do when the principal becomes due? That's probably not a great fit.

HORSLEY: Gabe del Rio works with a non-profit in San Diego that provides counseling and sometimes financial aid to first-time home-buyers. He worries some borrowers with modest incomes will use an interest-only loan to get a foot in the door of home ownership. If they're not careful, he says, they could lose the door and the rest of the house.

Mr. GABE del RIO (Non-Profit Counseling Service): A lot of times we see people who, if they hadn't come to us and gotten the education and counseling, you know they would have gone to a broker. That broker--there's a lot of them out there that do great things, but there's also a lot of them out there who are `yes people.' And by yes people I mean they just tell you, `Sure, I can get you into a home; no problem.' Well, what they're putting you into that home with may not be the best step for you, and what seems like it's an OK thing now may in two years or three years turn into a nightmare.

HORSLEY: That's because when interest rates rise and principal comes due, a buyer will suddenly face a much larger monthly house payment. Meanwhile, he won't have paid anything towards the balance of the loan, and if home prices have dropped, even a little bit, a borrower could end up owing more than his house is worth.

Mr. del RIO: They can't afford the new payment, so how are they going to keep their home? I definitely would predict that we're going to see a lot more foreclosures in the coming years.

HORSLEY: Dough Duncan of the Mortgage Bankers Association says historically, adjustable rate mortgages have had a slightly higher delinquency rate than fixed rate loans. He says interest-only mortgages haven't been around long enough to know how they'll perform in a downturn. Scott Horsley, NPR News, San Diego.

STAMBERG: This is MORNING EDITION from NPR News. I'm Susan Stamberg.

RENEE MONTAGNE (Host): And I'm Renee Montagne.

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