Dangers of Interest-Only Refinancing

To avoid foreclosure, homeowners considering interest-only home refinancing loans need to be aware of the dangers of such loans. We'll explain a few of the pitfalls below.

Adjustable Rates

Most of the interest only home refinance rates you will find apply to loans with adjustable interest rates. By themselves, adjustable-rate mortgages have an inherent risk because buyers are subjected to steep rate increases when the market changes. Combining this type of loan with an interest-only mortgage augments the risk. When the rate of the loan is adjusted in the future, the new monthly payment is determined using the loan's original amount, in contrast to a fully amortizing ARM that uses the smaller balance.

For instance, consider an adjustable-rate mortgage with an interest-only period of 10 years and an initial interest rate of 4% that adjusts every six months. In the worst scenario possible, the rate would rise by 2% every six months, maxing out at 10% by the nineteenth month. In that month, the interest-only payment would be a whopping 150% more than the original monthly payment. By contrast, the monthly payment on a fully amortizing ARM would only be 82% more. Borrowers should consider these risks before comparing interest only home refinance rates.

Foreclosure

Interest only home loans have a higher rate of foreclosure than other types of mortgages because they rely so heavily on the appreciation of home values. At the end of the interest-only period, the balance of the loan will not have changed if the borrower made no principal payments. Consequently, if home values have depreciated during this time, the homeowner ends up owing more on the house than it is worth. This becomes an especially vexing problem when the homeowner chooses to sell the house or refinance the mortgage, which most homeowners do within 10 years of purchasing the home. The idea of growing equity through the home value appreciation instead of paying down the mortgage is a risky one that often results in foreclosure. Before you consider interest only home refinance rates, make sure you've thought about the possibility of home depreciation and how it will affect you.

The Quick-Paydown Myth

Some lenders push interest only home refinance rates by leading borrowers to believe that making extra payments on an interest-only mortgage will cause it to amortize more quickly than traditional mortgages. The only time this is true is when you compare the amortization of an interest-only ARM with that of a fixed-rate home loan with a higher rate, also assuming that the ARM's rate remains the same during the period in question. However, borrowers are often under the impression that the comparison is between interest-only and non-interest-only loans, when in reality, the comparison involves a fixed-rate and adjustable-rate mortgage.

On any kind of home loan, adjustable or fixed, an identical monthly payment will amortize the interest-only mortgage and the non-interest-only loan the same way. Conversely, if the rate is higher on the interest-only loan, which is usually true, the loan will amortize more slowly than a non-interest-only mortgage. Keep this principle in mind as you shop for interest only home refinance rates. Check out the interest only home loans 101 guide for more information.