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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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Rich Smith
TMFDitty

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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