Risks

Any investment carries with it a certain amount of risk. However, it may be fairly argued that an interest-only mortgage carries a higher risk for the average home-buyer than does a fully-amortized loan.

Risk can come from a variety of sources, but the two primary sources are deflation in property values and liquidity at the time of sale. Let’s start with the potential for property values to decline.

It may be hard for some people to believe, but real estate values do not constantly rise. In fact, there have been periods of severe deflation in the value of real estate. The reason this is an added risk for people who have interest-only loans is because interest-only loans are only for a specified number of years and at the end of that period of time the owner of the property is faced with an often-substantial payment of principal to make.

If housing values have dropped just at the time when the borrower needs to repay the principal amount of the original mortgage loan, it may be impossible for the borrower to refinance or to sell the property without suffering an out-of-pocket loss. For borrowers with sufficient assets this may not pose too great of a problem, but for the average homeowner who obtained the interest-only loan to conserve badly needed cash in the first place, this may prove to be a terrible burden.

It is also possible that interest rates may be high or that the housing market may be in a slump for some other reason at the time when the principal balance of the loan becomes due. If the borrower was counting on the sale of the property to pay off the principal portion of the mortgage, a sluggish housing market could be devastating.

Interest-only loans can work for many borrowers, but there are increased risks and borrowers must be aware of these risks and have a plan in place to overcome them.