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Tuesday, February 27, 2007

Many of my friends have taken ‘interest only’ loans. I am starting to wonder if I should consider one as well?

checkbook.jpgask_id.gifThere is a great amount of “interest” in these products in recent years. These loans are not really a new financial product. Interest only loans have always been offered by private banking divisions to high income, high net worth clients. What has changed is that just about every lender has rolled out these programs in recent years and they are thus offered to any and all borrowers. In my opinion, that’s the problem, or at least the beginning of— read on! To be fair, let’s lay out the structure, benefits, and risks of this very popular loan program.

Interest only loans are structured such that the minimum monthly payment is based on a simple interest calculation for anywhere from the first 3 to 10 years of the loan. While most commonly offered as adjustable rate loans, many lenders now offered fixed rate interest only loans. The most obvious and “seductive” benefit is that the monthly payment can be considerably less than a comparable self amortizing loan. The other major benefit of these loans is that when payments are made towards the outstanding principal balance, the next payment will be based on the new balance. This “recast” feature can be a valuable tool for those with the ability and willingness to prepay.

Herein lay the risks. Since most of the interest only loans out there are adjustables, borrowers face the risk that their rate can go up at a certain point (anywhere from 2 to 6%, depending on the lender and program).In addition, at a certain point the loan must begin to amortize. At that point each payment must contain sufficient principal so that the principal loan balance in paid in full by the end of the remaining loan term.

As a result the borrower who has made only the minimum, interest only, payment for the allowable time period will face a potentially substantial increase in payment even if the rate has not changed. The worst case scenario can occur for a borrower who has an interest only adjustable rate loan whereby the rates increases by the allowable maximum and they have not paid any additional dollars towards principal. Under these circumstances it is possible for the loan payment to double!

While clearly not appropriate for all buyers and borrowers, these programs can be a useful tool for those who fully understand the risks and benefits. Consulting with a knowledgeable mortgage professional can help you make that decision.

Doug Adler is a senior loan officer with JP Morgan Chase. He has 20 years of experience as a real estate finance professional and can be reached at (212) 789-4052. Doug's a regular contributor to comitini.com.