11/04/2007

The answer to this question isn't as straightforward as you might think. Disciplined, risk-tolerant investors should consider looking at unconventional loans where the principal can rise from year to year.

However, the vast majority of people should limit themselves to traditional fixed-rate mortgages — or, in some cases, adjustable-rate mortgages.

OK, so I've answered the question. But there is one type of exotic mortgage that I want to discuss further.



I once wrote a column saying that everyone should avoid interest-only loans. Then I got an interest-only loan.

Before I go on, let me say that I don't think most people can handle an interest-only loan, mainly because they are complicated.

When it comes to financial matters, I preach simplicity. If you don't fully understand a product, avoid it. Don't let a salesperson talk you into anything that you don't understand.

An interest-only loan isn't exactly what it says. It's not a 30-year interest-only loan. Typically, the interest-only period lasts about 10 years. You're responsible for paying off the entire principal in the remaining 20 years, which means payments will rise rapidly in year 11.

In addition, interest-only loans have adjustable rates. Usually, they start with a low fixed rate for the first five years; then, the rate becomes variable, moving up or down with a particular interest rate index.

Not paying any principal gives you more money to invest — and it can be a substantial sum.

Say you have a $200,000 mortgage. On a 30-year, 6 percent fixed loan, your monthly payment is about $1,200.

An interest-only loan would have an initial fixed rate of 5.75 percent and a starting monthly payment of $958, giving you $242 each month to invest. Of course, if your rates adjust upward, your payments would increase, giving you less to invest.

I assume that house owners would refinance their interest-only loans before starting to pay principal in year 11.

Many people worry that not paying principal puts them at higher risk of losing their homes. Let's run the numbers.

Consider a possible worst-case scenario, where you put down only 5 percent (or $10,000) on a $200,000 house. After five years under a traditional 30-year mortgage, you will reduce your mortgage by $13,200, giving you $23,200 equity in the house.

Under the interest-only mortgage, you have your original $10,000 down payment, plus $15,800 invested, assuming an annual return of 6.5 percent. So you're more liquid, and your net worth is greater under the interest-only scenario.

The bigger risk is sharply rising interest rates after the initial rate goes away. As interest rates rise, you'll have less to invest.

However, almost all house buyers, even those with fixed-interest rates, have interest-rate risk because they don't live in the same house for 30 years. Most move every five to seven years, which requires a new mortgage and a new interest rate.



Growing wealthy slowly but steadily requires a balanced portfolio.



Next week, I'll look at when it makes sense to pay down your mortgage quickly and the limitations of my mortgage strategy. I'll follow that with some interesting responses I've been getting to these mortgage columns.