Interest-only mortages surge. Are they time bombs?

Borrowers who want low initial monthly payments coupled with the security of a fixed rate are turning to so-called “interest-only” loans in a big way. UBS AG reports an increase in fixed-rate interest-only loans to $39 billion in 2005 from $7.9 billion the previous year, adding that they now account for 8 percent of all residential purchase loans.

The main problem with these loans is that the monthly payment covers only interest initially, so at some point it goes up significantly. At that point the payment becomes higher than it would have been with a conventional mortgage because the interest rate is typically higher, from one-eighth to three-eighths of a point.

When that happens, the borrower might be unable to meet the new payments and the whole situation blows up.

The counter argument is that over the period of interest-only payments (sometimes as long as 15 years) the value of the house will have risen, building equity which can then be tapped. That’s fine, unless house prices decline or stay flat.

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