Interest-only mortgages are all the rage right now… Money magazine claims that as many as 70% of new home loans are interest only (in hot markets).
Here’s how money magazine descibed the workings of an interest-only loan:

What people commonly call an interest-only mortgage isn’t one particular type of loan. Rather, interest-only is an option that can be attached to any mortgage.

And in every case, after a certain time (usually five, seven or 10 years) the mortgage becomes fully amortizing, and you must pay both interest and principal. Because you’re repaying the principal in 20 or 25 years, not 30, those principal payments are higher than they would have been.

Other than that, the terms are as varied as those on any other mortgage — anything from a one-month adjustable rate to a 30-year fixed. IOs generally have a slightly higher rate (about a quarter of a percentage point) than the same loan without the interest-only feature (one reason lenders like them). But for most borrowers, that’s a small price to pay for the deep savings that interest-only payments represent.

Jack Guttentag (a professor at Wharton) had a much more skeptical (and I think more interesting) article on interest-only loans that dived a little deeper into the history of these types of loans. He describes how interest-only loans were all the rage in the 1920s…

However, the drop in real estate values during the Depression pushed a large proportion of interest-only loans into foreclosure. Lenders switched entirely to fully amortizing loans, and that has been the standard mortgage loan since.

Mr. Guttentag concludes that interest-only loans are “gimmickry, misdirection, and misperception” and that “if you don’t need an interest-only mortgage to qualify for the house you want to buy, it is not the best choice. ”

Of course, this is only one perspective on interest-only loans, but I find it highly interesting. If you are thinking of using an interest-only loan, I’d be interested to know why…