Take and Interest in Rates

Even if you're buying for yourself, you can make a colossal mistake by choosing the wrong mortgage. Given the sharp rise in home prices, creative lenders have started to push a type of loan called an interest-only mortgage. As the name implies, you pay just interest, no principal, for a set period, say, seven years. The allure is that your initial monthly payments are lower. For example, a $200,000 interest-only mortgage with a 6 percent rate will cost you $1,000 a month, whereas a "regular" mortgage, with which you pay both interest and principal, will run $1,200.

There's a catch, right? At some point, you must start paying back the principal. If you paid only interest for the first five years of a 30-year loan, you'll have to pay off the principal in the final 25 years. That translates into a sharp rise in monthly outlay. In California, 48 percent of new 2004 mortgages were interest-only, compared to 2 percent in 2001. If rates go up and/or property stagnates, this is a ticking time bomb.

I know that lenders tell you there's an easy solution: Well before your mortgage converts to the principal-paying phase, you either refinance with a standard 30-year mortgage, or you sell. Hello! There is absolutely no guarantee that you'll be able to do either. You could find yourself refinancing when rates are much higher. You could lose your job and no longer qualify as a refinance candidate. Or, if the market cools, you may not be able to sell at a big enough profit to recoup your broker's commission. Let me put it another way: If you can't afford to buy without an interest-only loan, you can't afford to buy.

And please don't be enticed by a one-year or even a three-year adjustable-rate mortgage. We're clearly in a period of rising interest rates, meaning that any adjustment is going to be up. That said, it can be smart to choose a "hybrid" loan that stays fixed for the first five, seven, or ten years. Your initial interest rate will be slightly lower than the rate on a standard 30-year loan—the key is to sell or refinance before the adjustable phase kicks in. If you're the average owner, who moves every seven years, that works out fine.

Given current interest rates, however, I still think your best option is a 30-year fixed mortgage, one with principal and interest payments that you can afford. These old-fashioned loans are hovering at a superlow 6 percent right now. Sure, that's higher than the 5.5 percent of 2003, but in 2000 the same loan carried a rate of 8 percent. If you plan to stay put, a 30-year fixed-rate promises the ultimate peace of mind.

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