One of the fairy tales borrowers frequently hear is that a loan carrying an interest-only (IO) option is priced better than the same loan without the option. It is a fairy tale because the IO allows the borrower to avoid paying down the loan balance, which makes it riskier to the investor, and greater risk should mean a higher price.

One of the fairy tales borrowers frequently hear is that a loan carrying an interest-only (IO) option is priced better than the same loan without the option. It is a fairy tale because the IO allows the borrower to avoid paying down the loan balance, which makes it riskier to the investor, and greater risk should mean a higher price.

At the wholesale level, where prices are extremely competitive because they are directed to mortgage brokers, the IO version of a loan always carries a higher price than the same loan without the IO option. This is also true at retail Internet shopping sites, such as those of the Upfront Mortgage Lenders (UMLs) listed on my site. Sometimes the price difference is small, sometimes it is large — but I have never seen IOs priced lower.

Yet in the bazaar-segment of the retail market, where borrowers deal one-on-one with mortgage brokers and loans officers (collectively "loan providers"), anything can happen. A trusting borrower without knowledge of competitive prices, dealing with a sales-hungry loan provider, could be told that the IO was priced better. The purpose of the fairy tale would be to move the deal forward. Here is an example:

"I read your postings on interest-only loans but it didn’t seem to apply to my situation. My broker gave me the option of a 30-year fixed-rate mortgage at 6.125 percent, or an interest-only (first 10 years) with a fixed 30-year rate of 5.875 percent. My plan was to take the interest-only but make the larger payment that I would have had on the amortizing loan. This should save me money…"

I don’t have any facts other than those in the letter above, and can only speculate about the source of the misinformation. All those cited below I have run into at one time or another.

Perhaps the most plausible explanation is that the 6.125 percent rate was simply concocted out of thin air to make the 5.875 percent rate on the IO look good. A borrower who gets all his information from a loan provider is vulnerable to such chicanery.

A second possibility is that the IO is on an adjustable-rate mortgage (ARM), rather than a fixed-rate mortgage (FRM) as the borrower was led to believe. ARMs typically are priced lower.

A third possibility is that both rates are correct but the loan provider left out other loan charges, including points. As an illustration, I just went to an online site and priced a 6.125 percent 30-year FRM against a 5.875 percent IO version of the same loan. Both loans were there, but the second cost 2.3 points more than the first.

A final possibility is that the loan provider was "lowballing" the IO rate and had no capacity to deliver the 5.875 percent quote. The market changes every day and loan providers can’t be held to quotes until they are locked. Between the quote day and the lock day, they can choose from a wide selection of explanations as to why the rate is higher, including a general change in the market and a re-evaluation of the borrower’s credit.

The upshot is that borrowers cannot be confident that loan providers are giving them reliable information about price differences between different loan options. Many loan providers will, but some will exploit the borrower’s ignorance for their own benefit.

A Reverse Mortgage Can Help an Elderly Homeowner Avoid Foreclosure

Few things irritate me as much as hearing about the foreclosure of an elderly homeowner who had substantial equity in his house. This shouldn’t happen. Elderly homeowners who can no longer afford their mortgage payments and taxes but have substantial equity in their house can pay off the mortgage with the proceeds of a reverse mortgage.

Of course, they can also repay the mortgage by selling the house, but then they have to move out. The virtue of the reverse mortgage is that they can pay off the mortgage and stay in the house, and perhaps even have a little more spending money, depending on their age and how much equity they have. For example, a married couple both 80 with a house worth $550,000 and a mortgage of $170,000 could pay off the mortgage and get an additional credit line of about $75,000 to use as they please.

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? Leave your comments below or send a letter to the editor. To contact the writer, click the byline at the top of the story.

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