7 reasons to avoid interest-only loans

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Interest-only loans are one of the two most dangerous types of mortgages. (Option ARMs are the other.)

They appeal to borrowers who can't afford the home they want with a traditional fixed-rate mortgage and are desperately looking for a loan with lower monthly payments.

Too many take a chance on interest-only loans because:

When the payments shoot up -- and they always do -- a shocking number of borrowers can't come up with the money, can't refinance and can't sell. That's why thousands of borrowers with interest-only loans are losing their homes to foreclosure.

Don't become one of them.

Here are the 7 reasons to avoid interest-only loans:

Reason 1. You'll still owe all that money.

If you borrow $250,000, your monthly payments only cover the interest on that debt. After you've written 10 or 20 or even 60 checks, you'll still owe $250,000. That's no way to build a family nest egg.

Reason 2. You won't reduce your mortgage voluntarily.

It's easy to convince yourself that you'll add a little extra to each check to pay down the principal. But it's also easy to convince yourself that you'll go on a diet, give up sugar and caffeine, go jogging every morning, and lose 35 pounds before your next class reunion. Some people do it. Most of us don't.

The vast majority of homeowners with interest-only loans don't have enough money to voluntarily spend more on a mortgage. If they did, they would have taken out a traditional fixed-rate loan.

Reason 3. Eventually you'll have to begin paying off the principal and your monthly payments will go up.

That usually happens five years into the loan.

Let's say you got that $250,000 loan at 6%. Your monthly interest-only payment would be $1,250. That's about $250 a month less than if you'd financed the loan with a 30-year, fixed-rate loan.

When you start repaying the debt, the payment climbs to $1,610 -- an increase of $360 or nearly 30%. Now you're paying $110 more than with a traditional loan.

That also assumes your interest rate remains at 6% -- something that almost never happens.

Reason 4. Most interest-only loans are also adjustable-rate loans.

When you begin to repay the principal, the interest rate also resets for the first time. The new rate is almost always higher than the initial rate and you can expect it will be more than fixed-rate loans cost at that time.

If the interest rate on that $250,000 loan increases a single percentage point to 7% -- and most loans allow rates to jump at least two percentage points the first time they reset -- the monthly payment will be $1,767.

That's a sizable increase of $517 or nearly 42% and pushes your payment to about $270 more than a traditional loan.

Reason 5. You can't count on refinancing.

Many borrowers expect to refinance to a more affordable loan before they have to cope with higher monthly payments.

But refinancing is never a sure thing. Just ask all the homeowners who can't refinance their interest-only loans right now.

Lenders are imposing stricter application requirements that require borrowers to have higher incomes, less debt, better credit histories and more equity in their homes -- at least 5% to 10%.

Homeowners who fall short in some way:

Reason 6. You can't count on home prices going up.

The major reason homeowners can't refinance at any price is that they don't have enough equity in their homes.

Borrowers who take out interest-only loans assume their homes will appreciate in value, allowing them to build equity without paying down the mortgage.

That made some sense when home prices jumped 51% between 2001 and 2005.

But home values are now stagnant, or falling, in most parts of the country. They rose only 1.4% last year and the National Association of Realtors expects they'll fall an average of 1.4% this year. In the worst-hit cities, prices may drop 10% or more.

Reason 7. You can't even count on being able to sell.

A surprising number of borrowers can't do it because selling a home costs money -- typically 10% of the sale price. The real estate agents usually get 6% and the rest goes for fees and other costs.

Let's say you bought a $250,000 house with an interest-only loan and 5% down payment that required you to borrow $237,500.

If you sold it for $250,000 the first $237,500 would go to the lender and the remaining $12,500 would cover only half of the selling costs. You'd need another $12,500 in cash to close the deal.

Don't have it? Can't sell.

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