A Suze Orman exclusive

Having dropped this ominous prognosis, let me explain exactly how these interest-only loans make it so much more likely that an individual investor will default.

Let’s begin with this basic truth: interest-only loans were invented by mortgage lenders who know that fewer and fewer folks can afford homes in the hottest locations using a standard 30-year fixed rate mortgage, but who, with all the money being made in these boom markets, are desperate to hook people into mortgages any way they can. So they came up with a loan to make you feel as if you can afford to buy, by requiring that you pay only the interest in the early years of the mortgage. The catch, of course, is obvious. In a way, it sort of reminds me of the tobacco industry: selling glamour and gratification up front, at the heavy risk of dire problems down the road.

With interest-only mortgages, the risk is to your financial health. Look at the most conservative of all interest-only loans, the fixed rate interest-only mortgage where you pay interest-only in the first five years (or whatever term you decide on) of a 30-year mortgage. All that means is that you get an easy ride for five years, then are required to get all the principal paid off in the remaining 25 years of the loan. Your payments are smaller than normal for five years, then larger than normal for the next 25.

Oh sure, a lender who is pushing the interest-only mortgage will tell you not to worry. You’ll be making more in five years (or whenever your principal payments are set to begin) so you’ll be able to afford the hike. Excuse me? Where is it written in today’s economy that you are guaranteed to be making more? And don’t fall into the “you’ll just refinance” trap either. How can you be sure you will be able to refinance? What if home prices tread water for a few years, so you don’t have a lot of built-up equity? Or what if interest rates are 7 percent or 7.5 percent rather than today’s 5.8 percent? You get my point.

But the above example is just one kind of interest-only loan; they come in many shapes and forms. One of the most popular of all interest-only loans, according to Barry Habib of the Mortgage Market Guide, is the “Adjustable Rate Mortgage” (ARM). With adjustable rate mortgages, the start rate is lower than on a fixed rate mortgage, but the rate can change and payments may increase over time. An interest-only adjustable rate mortgage makes the short-term payment savings even greater, but has an additional element of rate change risk.

Another type of interest-only loan is commonly called the “Option ARM.” This loan gives you the option to make a regular payment covering principle and interest, an interest-only payment, or even a payment that does not cover the full amount of interest due. In this case, the unpaid interest is tacked on to the loan balance, which actually increases the outstanding loan amount over time. This is known as “negative amortization.” For example, a $200,000 loan could have a minimum payment due of only $333, which is a whopping $867 monthly payment reduction compared to a normal loan! It’s little wonder that these loans have become so popular. But the attractive low payment comes with a vicious kicker, since you are adding tens of thousands of dollars to the balance you owe on your mortgage. Meanwhile, you have to hope that you can keep your loan balance neck-and-neck with home appreciation rates so you don’t end up “upside down” on your home, owing more than it is worth. You’re living on borrowed time….It’s almost like treating your home as a credit card!

The moral is that there is no free lunch here, my friends. All that happens with interest-only loans is you put off when the real bill arrives. And when it does come—when the principal payments kick in—you are going to be hit with a big hike in your mortgage bill. Interest-only mortgages truly require some massive leaps of faith—an optimism that often turns out to be misplaced, and sometimes even ruinous.