“Does it make sense to use an interest-only loan to buy the home of our dreams? We feel that is the only way we will be able to afford it. We are near retirement age and will have significant equity in the house, but our income isn’t large enough to afford more than the interest payment. I feel that in case of an emergency, we could apply for a reverse mortgage.”

It does make sense, but the reverse mortgage should be made an explicit part of your plan, not just an emergency backup. You can’t make interest-only (IO) payments forever, so you want to pay off the loan with proceeds from a reverse mortgage before the IO period ends.

As far as I know, the longest interest-only period available today is 10 years. If you take a 30-year loan that is IO for 10 years, in month 121 your payment will rise to become fully amortizing. The new payment will have to be large enough to pay off the loan over the next 20 years.

That should not be a problem if you and your spouse are older than 52 now and have significant equity in the house. You will become eligible for a reverse mortgage at 62, before your mortgage payment increases. You pay off the loan with the proceeds of a reverse mortgage, and hopefully have enough equity left over to do some traveling or send a grandkid to college.

WARNING: Most IOs today are adjustable-rate, which involves the risk that the payment may increase markedly well before the IO period is over. You are not in a position to take this risk, which means you must have a fixed-rate IO.

Does the Mortgage Market Reward Virtue?

“I am tired of seeing mortgage ads that say ‘perfect credit not required.’ I have spent all my adult life exercising exceptional financial responsibility and now I have a credit score of 800 to show for it. I would like to know what sort of leverage this gives me in my hunt for a mortgage? Can I negotiate a better interest rate, reduce points or waive some fees? Please tell me that my diligence will yield some tangible benefits.”

Sorry to disappoint you, but in most cases the mortgage market does not reward virtue, rather it penalizes vice. That means that you qualify for the best prices available, which will not be offered to those with poor credit. The ads that say “perfect credit not required” don’t say that those with imperfect credit will pay the same price that you pay, and in fact they will pay more.

Lenders want to advertise the lowest prices possible, so they base their posted prices on favorable assumptions. One of them is that the borrower has good credit. Some others are that the property is single-family, that it will be occupied as a permanent residence, that the borrower can document sufficient income to meet the payment obligation, and so on. Deals that don’t meet these specifications are priced higher.

Your credit score of 800 (out of a maximum of 850) exceeds the minimum required for the best prices. While the minimum varies from one program to another, 720 is widely used. Where that is the case, a borrower with 720 would pay the same price as you, but a borrower with 650 would pay more.

There is one situation, however, where having an exceptional credit score, as opposed to merely a good one, might pay off. Your transaction might not meet all the other specifications of a loan that commands the best pricing. For example, the ratio of housing expense to income might be well above conventional standards, or you might not be able to make a down payment, or document your income. In such cases, an 800 score could keep you in the best-price category, or close to it, where a 720 score would not.

Moral: an exceptionally high credit score is a great thing to have if you lack one of the other requirements for the lowest possible price.

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.


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