One of the fairy tales borrowers frequently hear is that a loan carrying an interest-only (IO) option is priced better than the same loan without the option. It is a fairy tale because the IO allows the borrower to avoid paying down the loan balance, which makes it riskier to the investor, and greater risk should mean a higher price.

At the wholesale level, where prices are extremely competitive because they are directed to mortgage brokers, the IO version of a loan always carries a higher price than the same loan without the IO option. This is also true at retail Internet shopping sites, such as those of the Upfront Mortgage Lenders (UMLs) listed on my site. Sometimes the price difference is small, sometimes it is large — but I have never seen IOs priced lower.

Yet in the bazaar-segment of the retail market, where borrowers deal one-on-one with mortgage brokers and loans officers (collectively "loan providers"), anything can happen. A trusting borrower without knowledge of competitive prices, dealing with a sales-hungry loan provider, could be told that the IO was priced better. The purpose of the fairy tale would be to move the deal forward. Here is an example:

"I read your postings on interest-only loans but it didn’t seem to apply to my situation. My broker gave me the option of a 30-year fixed-rate mortgage at 6.125 percent, or an interest-only (first 10 years) with a fixed 30-year rate of 5.875 percent. My plan was to take the interest-only but make the larger payment that I would have had on the amortizing loan. This should save me money…"

I don’t have any facts other than those in the letter above, and can only speculate about the source of the misinformation. All those cited below I have run into at one time or another.

Perhaps the most plausible explanation is that the 6.125 percent rate was simply concocted out of thin air to make the 5.875 percent rate on the IO look good. A borrower who gets all his information from a loan provider is vulnerable to such chicanery.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

***

What’s your opinion? Leave your comments below or send a letter to the editor. To contact the writer, click the byline at the top of the story.

Show Comments Hide Comments
Sign up for Inman’s Morning Headlines
What you need to know to start your day with all the latest industry developments
By submitting your email address, you agree to receive marketing emails from Inman.
Success!
Thank you for subscribing to Morning Headlines.
Back to top
Only 3 days left to register for Inman Connect Las Vegas before prices go up! Don't miss the premier event for real estate pros.Register Now ×
Limited Time Offer: Get 1 year of Inman Select for $199SUBSCRIBE×
Log in
If you created your account with Google or Facebook
Don't have an account?
Forgot your password?
No Problem

Simply enter the email address you used to create your account and click "Reset Password". You will receive additional instructions via email.

Forgot your username? If so please contact customer support at (510) 658-9252

Password Reset Confirmation

Password Reset Instructions have been sent to

Subscribe to The Weekender
Get the week's leading headlines delivered straight to your inbox.
Top headlines from around the real estate industry. Breaking news as it happens.
15 stories covering tech, special reports, video and opinion.
Unique features from hacker profiles to portal watch and video interviews.
Unique features from hacker profiles to portal watch and video interviews.
It looks like you’re already a Select Member!
To subscribe to exclusive newsletters, visit your email preferences in the account settings.
Up-to-the-minute news and interviews in your inbox, ticket discounts for Inman events and more
1-Step CheckoutPay with a credit card
By continuing, you agree to Inman’s Terms of Use and Privacy Policy.

You will be charged . Your subscription will automatically renew for on . For more details on our payment terms and how to cancel, click here.

Interested in a group subscription?
Finish setting up your subscription
×