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Interested in Interest-Only?

My Foolish colleagues Selena Maranjian and Chris Mallon have written more than once to warn homebuyers about the perils of interest-only home mortgages. But The Motley Fool isn't just investors writing for homebuyers, you know. On occasion, we write for investors, too. Today, I want to take a look at the risks that interest-only mortgages pose to investors in the banks offering these seemingly sweet (again, to homebuyers) deals.

In an interest-only mortgage, you pay nothing toward your principal debt for the first few years. On a $200,000 mortgage, for instance, a traditional 30-year-fixed mortgage at 6% might run you $1,500 a month, including principal, interest, real estate taxes, and insurance. Remove principal from the equation, and the payments drop to $1,300.

If you can't afford a $1,500 payment but $1,300 is manageable, if you plan to own the home for only a few years, or if you intend to resell it before the principal payments kick in, this arrangement can look like a great deal. But if interest rates increase, so, too, may problems. Most interest-only loans are of the "adjustable rate" variety, meaning that the 6% interest you start out paying can increase. Some of these mortgages adjust the interest rate every month.

Let's attach a dollar figure to this phenomenon. For every 1% increase in the interest rate, the payment on our hypothetical mortgage increases by $167. All it takes is a 2% rate hike to push that $1,300 payment to well over $1,600, and perhaps beyond a homebuyer's ability to pay. Bad situation for the homebuyer? Sure. But this also could spell trouble for lenders such as Countrywide Financial (NYSE: CFC  ) , Wells Fargo (NYSE: WFC  ) , J.P. Morgan Chase (NYSE: JPM  ) , and many other banks offering this flavor of mortgage. Why? Because homebuyers using an interest-only mortgage do not build equity in their homes and so have less to lose by walking away from a house, and a mortgage, when they can no longer afford either.

If interest rates continue to rise, there's a good chance we'll begin to see a rise in such "walk-aways" and a consequent rise in the number of banks getting stuck with foreclosed houses they don't necessarily want. Simultaneously, we'd expect house-price appreciation to slow or reverse, since higher interest rates make houses less affordable. Assuming that both trends hit simultaneously, as seems likely, these banks could be setting up a situation in which they find themselves in possession of a lot of houses, just as houses become harder to unload on the market. And that would spell trouble for the banks and their investors alike.

For a homebuyer's-eye view of interest-only mortgages, read Selena's and Chris's excellent write-ups:

Fool contributor Rich Smith has no position in any of the companies mentioned in this article.

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