How Much More Does Interest-Only Cost?
March 6, 2006, Revised December 21, 2006, May 21, 2009

"You have stated that interest-only loans cost more, but how much more?"

Quite a lot, actually, but it tends to be obscured.

Interest only (IO) is an option available on some loans that allows the borrower to pay only interest – no principal – for some years, usually 5 or 10. After the IO period is over, the payment will increase by the amount required to pay off the loan over the period remaining to term.

Borrowers pay for the option. Because of the delay in reducing the loan balance, lenders view IO loans as riskier than loans that begin amortizing immediately. Naturally, they charge for this risk. Among two loans that are identical except that one has an IO option, that one will be priced higher.

Unfortunately, this fact is often obscured. Loan officers and mortgage brokers have a bad habit of comparing the prices of adjustable rate mortgages (ARMs) that have IO options with fixed-rate mortgages (FRMs) that don’t. Since ARMs have lower prices than FRMs, this creates a false impression that the IO is associated with lower prices, when just the opposite is the case.

I recently compared the wholesale prices of 30-year FRMs with and without IO options in a variety of market niches. Wholesale prices are those quoted by major lenders to mortgage brokers and small lenders. They become retail prices after the brokers and small lenders add their markup. All prices assume the borrower has good credit and puts 20% down.

On a home purchase mortgage of $300,000, I found a wholesale rate difference of about .375%. On a purchase for investment, the rate difference was almost .625%. On a cash-out refinance covering an owner-occupied home where neither income not assets are documented (called "NINA"), the rate difference was almost .875%. And on the same loan covering an investment property, the rate difference exceeded 1%. Similar differences arise on ARMs.

The increasing rate differences reflect the way in which risk factors reinforce each other. Lenders view IO as riskier on mortgages that are already risky, because e.g., they are cash-out, or on investment properties, or involved minimal documentation, and so they charge more for the option on those types of loans.

In 2009, because of the financial crisis, these differences were substantially larger. The difference of .375% on a purchase loan for occupancy had grown to 1%.

"You say that it costs more for an interest-only loan, but my lender is giving me one for the same price. Is it possible that the professor is wrong about this?"

It is always possible that the professor is wrong, but he is not wrong about this. He has checked wholesale price quotes from many lenders, covering many different loan types. Invariably, if two loans are otherwise identical, the interest-only (IO) variant is priced higher.

The wholesale market is composed of very large lenders who fund mortgage brokers and smaller lenders, called "correspondents". This market is extremely competitive, because the brokers and lenders who select from among the different wholesalers are knowledgeable and careful shoppers. That’s why I look to the wholesale market for evidence on price relationships among different mortgage types.

In the retail market, in contrast, these relationships can be obscured by a wide disparity in markups. Retail markups of the wholesale price vary both with the practices of retail loan providers, and with the sophistication and shopping acumen of borrowers.

Here is an example. Borrower A comparison shops on-line and finds the best deal on a 30-year fixed-rate mortgage is 6% with the IO version at 6.125%. Borrower B, who is identical except in smarts, is solicited by a high-priced lender who quotes 6.5% for the same mortgage, and when B asks about an IO, this lender generously offers it at the same price.

Conclusion: if your loan provider doesn’t charge extra for an IO, you are being over-charged.
 
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