Real Estate

Built on the assumption that home prices will continue to rise, interest-only mortgages represent a gamble that many home owners accustomed to conventional fixed-rate loans would never take. Unlike conventional 30-year mortgages, interest-only loans typically don't require payments toward the principal for three to seven years, substantially lowering the costs of entry and making it easier to qualify for the loan. [1]

But the financial firepower of interest-only mortgages is affecting all home owners. They are further elevating already lofty housing prices, a trend that's raising fears of crash that could plunge the economy into a recession. "When this market adjusts, it's going to be painful," said UCLA economics professor Edward Leamer, who has been warning of a California housing bubble for three years. "Borrowers are getting in over their heads, and lenders are too."

The growth of interest-only mortgages reflects a fundamental shift in the way many Americans think of their homes. Rather than places to grow old in, they see homes as part of their investment portfolios — in fact, a much better bet than the stock market in recent years. In California alone, homeowner equity has grown by a whopping $1 trillion since 2000, according to the California Building Industry Association. Even borrowers who can afford the higher payments of a conventional mortgage are opting for interest-only loans, so they can free up more cash to invest in retirement plans, college education funds or other home purchases, [2] said Mark Carrington, director of information products for LoanPerformance, a mortgage research firm.

[1] Yes, interest-only loans typically don't require payments toward the principal for 3-7 years, but at the end of this period eventually you *will* have to start paying down principal and/or re-finance your loan (either of which will result in a higher payment). Furthermore, we are in a period of historically low rates, and interest-only loans are generally variable-rate. So at the end of the interest-only period, rates will almost certainly be higher, causing payments to be even higher still. People are jumping into these loans under the assumption that their income will be substantially higher in 3-7 years; in most cases that assumption is unwarranted.

[2] Retirement investments or college funds would not be an altogether bad reason to do this. However, this statement is inaccurate. In most cases, the only reason people get into these loans is to buy a lot more house than they could otherwise be approved for (and often a lot more house than they can actually afford). Their payment is still a stretch, and any savings are used to finance current consumption not investing.