Q: “You have stated that interest-only loans cost more, but how much more?”

A: Quite a lot, actually, but it tends to be obscured.

Interest-only (IO) is an option available on some loans that allows the borrower to pay only interest–no principal–for some years, usually five or 10. After the IO period is over, the payment will increase by the amount required to pay off the loan over the period remaining to term.

Borrowers pay for the option. Because of the delay in reducing the loan balance, lenders view IO loans as riskier than loans that begin amortizing immediately. Naturally, they charge for this risk. Between two loans that are identical except that one has an IO option, that one will be priced higher.

Unfortunately, this fact is often obscured. Loan officers and mortgage brokers have a bad habit of comparing the prices of adjustable-rate mortgages (ARMs) that have IO options with fixed-rate mortgages (FRMs) that don’t. Since ARMs have lower prices than FRMs, this creates a false impression that the IO is associated with lower prices, when just the opposite is the case.

I recently compared the wholesale prices of 30-year FRMs with and without IO options in a variety of market niches. Wholesale prices are those quoted by major lenders to mortgage brokers and small lenders. They become retail prices after the brokers and small lenders add their markup. All prices assume the borrower has good credit and puts 20 percent down.

Wholesale prices are better than retail prices for checking the price differences between different types of mortgages. Wholesale price quotes are competitive because they are directed at brokers and small lenders who constantly compare one price with another. Retail price quotes, in contrast, include much “noise” because markups vary widely and quoted prices are not always dependable. For example, when borrowers report to me that they were offered the same price for an IO as for a non-IO, I know the loan provider cut the markup on the IO (or perhaps raised the markup on the non-IO) in order to close the deal.

On a home purchase mortgage of $300,000, I found a wholesale rate difference greater than 0.375 percent. On a purchase for investment, the rate difference was almost 0.625 percent. On a cash-out refinance covering an owner-occupied home where neither income nor assets are documented (called “NINA”), the rate difference was almost 0.875 percent. And on the same loan covering an investment property, the rate difference exceeded 1 percent. Similar differences arise on ARMs.

The increasing rate differences reflect the way in which risk factors reinforce each other. Lenders view IO as riskier on mortgages that are already risky, because, for example, they are cash-out, or on investment properties, or involved minimal documentation, and so they charge more for the option on those types of loans.

Take An IO to Pay Down a Second Mortgage More Rapidly?

Q: If you take a combination first and second mortgage, wouldn’t it save money if you made the first mortgage IO and used the cash-flow saving to pay down the higher-rate second?

A: If the rate on the first was the same with and without IO, you would indeed save money by taking the IO on the first and applying the payment saving to a more rapid reduction of the balance on a higher-rate second. Assuming the rate on the first is higher with than without the IO, however, which is the case, the savings from paying down the high-rate second mortgage tend to be offset by the higher interest payments on the first. Where you come out is not clear.

To get a handle on it, I constructed a little spreadsheet. The spreadsheet showed that a strategy of using the cash flow saving on an IO first mortgage to accelerate the pay-down of a high-rate second was not promising. You had to stick with it for some years before you could possibly end up ahead. Further, even over a long period, it will only work if you pay a rate no more than 0.125 percent higher for the IO as opposed to the non-IO version of the first mortgage, and only if the second mortgage rate is at least 2.5 percent higher than the rate on the IO first. These conditions are not likely to arise very often.

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

***

What’s your opinion? Send your Letter to the Editor to opinion@inman.com.

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