Adjustable-rate risk is crucial question

“I plan to pay off my home loan as soon as possible using an interest-only mortgage. Here are the figures provided by my loan officer: The payment on the 30-year, 5.5 percent fixed-rate mortgage is $567.79 for each $100,000 of loan, of which only $109.46 is reduction of principal. On the interest-only, the rate is 3 percent and the payment only $250. If I take the interest-only, but make the fixed-rate mortgage payment of $567.79, $317.79 of it will be applied to principal. This means that I will pay off my loan much sooner. Right?”

I receive letters similar to this one every day, and the number of them seems to be increasing. The pitch is evidently very effective with more loan officers adopting it. Interest-only is hot, and one major reason why is that it is now being sold as a way to amortize a mortgage more quickly.

A fascinating thing about the rapid amortization pitch is that it is the exact opposite of an earlier and still popular pitch for interest-only mortgages: that the lower payment allows the borrower to invest the payment savings and earn a return higher than the mortgage rate. The earlier pitch was for no amortization. “Why invest in repaying your mortgage balance, which is only costing you 5.5 percent, when you could put that money into common stock that will yield 10 percent or more,” borrowers were told.

 The no amortization pitch for interest-only is straightforward. Most borrowers understand the costs and potential benefits of investing (or spending) money that would otherwise go to paying down the loan balance. The rapid amortization pitch, in contrast, is extremely deceptive.

All the numbers the loan officer gave you are correct. But the impression he left with you, that interest-only is the reason for the rapid amortization, is false.

The interest-only loan amortizes more rapidly than the fixed-rate mortgage because the interest rate is lower. The rate is lower not because it is interest-only, but because it is an adjustable-rate mortgage. Rates are lower on adjustable-rate mortgages than they are on fixed-rate mortgages because adjustable-rate mortgages expose the borrower to the risk of future rate increases. The real choice is not between interest-only and non-interest-only, but between fixed-rate mortgage and adjustable-rate mortgage.

Why does it matter whether the borrower understands the choice as fixed-rate mortgage versus adjustable-rate mortgage rather than interest-only versus non-interest-only?

Because borrowers who understand that the issue is fixed-rate mortgage versus adjustable-rate mortgage probably will realize they need to know how long the rate quoted on the adjustable-rate mortgage will last, and what can happen to the rate after that initial rate period ends. Borrowers who view the issue as interest-only versus non-interest-only don’t ask these critical questions, as you didn’t.

For example, you didn’t ask your loan officer how long the 3 percent rate on the adjustable-rate mortgage would hold. The chances are that it is good for only six months. If that is the case and if the adjustable-rate mortgage has a rate adjustment cap of 1 percent, then in a rising rate market your rate would rise to 4 percent after 6 months, 5 percent after 12 months and 6 percent after 18 months. After 18 months, the adjustable-rate mortgage could start amortizing less rapidly than the fixed-rate mortgage.

The adjustable-rate mortgage you were offered might or might not make good sense for you. But whether it does or not depends on its adjustable-rate mortgage features, not on whether it is an interest-only.

Framing the decision as interest-only versus non-interest-only, rather than fixed-rate mortgage versus adjustable-rate mortgage, also obscures the fact that interest-only is an option for which borrowers usually have to pay. Without the interest-only option, your loan might be available at 2 7/8 percent rather than 3 percent. It makes sense to pay for the interest-only option only if you intend to use it.

Borrowers who want to maximize the cash flow they have available for investment need the interest-only. But borrowers such as you who want to maximize the cash flow available to repay their loan balance, don’t need it. You didn’t ask about the possibility of getting a lower rate by giving up an option you didn’t intend to use because you didn’t know it was an option.

The strategy of taking a low-rate adjustable-rate mortgage while making the larger payment that you would have had to make had you taken an fixed-rate mortgage is a good one. It reduces the risk associated with the adjustable-rate mortgage because if the adjustable-rate mortgage rate rises in the future, the payment increase won’t be as large. But this is a strategy for use with an adjustable-rate mortgage and has nothing to do with interest-only.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at MtgProfessor.com.