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During the housing boom, borrowers were able to use interest-only mortgage loans to reduce the size of their monthly payments. But a new rule scheduled to take affect in 2013 could make these loans all but extinct. Here’s what you need to know about it.

Definition of an Interest-Only Mortgage

An interest-only mortgage is a home loan scenario where the borrower only pays interest for a certain period of time. After that period, the borrower would begin making combined (regular) payments including both interest and principal. During the interest-only period, the borrower puts off repaying the principal amount borrowed in order to minimize the size of the monthly payments.

This practice is also known as deferring principal, because the borrower chooses to defer repaying the principal amount borrowed during the interest-only period.

The problem with interest-only loans is that the principal balance doesn’t go away during the loan’s initial phase. The borrower pays only interest during this period, so the principal amount borrowed remains the same. After that, the loan will amortize for the remaining term. For instance, if a borrower takes out a 30-year mortgage loan that is interest-only for the first 10 years, the full principal will eventually be amortized over the latter 20-year period. So the monthly payments in the second phase could be much larger than the payments during the first 10 years.

According to the National Bureau of Economic Research: “Interest-only mortgages trade off an increased probability of negative home equity against a relaxation of borrowing constraints, but overall have the highest probability of a default wave.”

A joint report by the Center for Responsible Lending and the Center for Community Capital at UNC noted that “research on mortgage default has shown that risky product features such as … interest only or negatively amortizing payments are strong and significant predictors of default.”

The bottom line is that interest-only loans correspond to a higher risk of default. They are considered to be a higher risk than ‘regular’ mortgages where the borrower begins paying down the principal from day one.

This is why you don’t see many of these loan scenarios anymore. Most lenders stopped offering them when the housing market collapsed, starting in 2008. While the interest-only mortgage is rare in the current lending market, they are still ‘legal.’ That is, there are no federal lending rules that prohibit the use of these loans. But that may change in the near future.

Dodd-Frank and QM Could Prohibit These Loans

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. It is intended to reform the financial industry in the United States, in order to prevent a repeat of the events that led up to the recession.

Among other things, the Dodd-Frank Act calls for the creation of a qualified mortgage or QM. This set of rules seeks to prevent high-risk mortgage loans from being originated. Here’s what it says about making interest-only payments by deferring the repayment of principal:

“The term ‘qualified mortgage’ means any residential mortgage loan … for which the regular periodic payments for the loan may not allow the consumer to defer repayment of principal…”

The Dodd-Frank Act allows for certain exceptions to this rule, but the language is vague. We expect clarification of these rules sometime in January 2013. The Consumer Financial Protection Bureau (CFPB) has a January deadline for finalizing the QM requirements. So at this time, we don’t know exactly what limitations they will impose. Based on the language used in the Dodd-Frank Act, however, it’s safe to assume the new rules will limit or prohibit the use of interest-only mortgage products in the United States.

We will know more in a month or two, and the website will be updated to reflect any changes.