Interest-only mortgages can be tempting, but consider potential risks, hurdles to qualifying

Home Mortgage Associated Press

Don't call it a comeback.

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Interest-only mortgages got a bad reputation in the aftermath of the housing bust, but they've managed to stick around as an option for homebuyers who can meet stricter lending guidelines enacted by the government in recent years.

The loans can lower monthly mortgage payments by letting borrowers put off paying the principal on their loan for several years. When the interest-only period ends, the borrower's monthly payment spikes as they begin to pay a combination of principal and interest until the loan is paid off.

That monthly payment shock, often accompanied by a higher interest rate on adjustable-rate interest-only loans, is what got many borrowers in trouble a decade ago.

One reason is that many of those borrowers qualified for their loans on the basis of their ability to repay the lower, interest-only payment. When their monthly payment reset higher, many couldn't keep up.

That's no longer the case. Now lenders are required to determine whether borrowers qualify for any interest-only loans, or other adjustable-rate mortgages, based on whether they can afford to make the eventual bigger monthly payments that await them once the initial interest-only period ends.

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As a result, such interest-only loans now make up only about 0.2 percent of all adjustable-rate mortgages, or ARMs, which account for about 4 percent of all home loans for purchase and refinancing, according to data from CoreLogic.

Use of interest-only mortgages peaked 10 years ago at the height of the housing bubble at around 10 percent of all ARMs.

"The big difference here is interest-only loans are back to being the niche product that they traditionally had been," said Greg McBride, chief financial analyst at Bankrate.com. "The go-go days of the housing boom were the exception."

Still, rising home prices can make interest-only loans a tempting option for borrowers who are interested in a lower mortgage payment and can qualify for such a loan under today's stricter guidelines.

At least one lender is looking to expand access to interest-only loans to a broader range of homebuyers, not just the affluent buyers who typically take advantage of such loans.

Last month, United Wholesale Mortgage began making interest-only home loans through its network of mortgage brokers. The loan program covers mortgages as low as $250,000. That's just above the U.S. median home price of $236,400, but well below the recent median price in Southern California of $426,000.

Even with today's stricter guidelines aimed at ensuring borrowers can handle interest-only loans, they carry potential financial risks. Here are some things to consider when weighing whether such a loan is right for you:

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PAYMENT CHANGES

Interest-only mortgages can come with a fixed or variable interest rate and an initial period when the borrower only pays interest on the loan. That's usually three, five, seven or 10 years. After the interest-only period, the monthly payment can increase sharply as the borrower begins to also pay down the principal on their loan.

In addition, the borrower is left with 20 years to pay off the balance of the loan.

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LENDING REQUIREMENTS

To ensure borrowers can afford an interest-only mortgage, lenders often require large down payments relative to what one can find with a traditional 30-year, fixed-rate home loan backed by the government.

For example, the down payment on a mortgage backed by the Federal Housing Administration can be as low as 3.5 percent, though the borrower will have to pay private mortgage insurance. And borrowers can qualify with a FICO score as low as 580.

In contrast, United Wholesale Mortgage requires that borrower put down 20 percent, have a FICO score of at least 720 and a debt-to-income ratio of 42 percent.

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BUILDING EQUITY

With a traditional mortgage, the borrower is paying part of the principal with every payment. That helps build their equity in the home along the way. In the initial period of an interest-only mortgage, the borrower is only gaining equity if their home is appreciating.