Mortgage lenders are becoming increasingly creative in their efforts to attract borrowers in a heated housing market that shows no sign of simmering down. One of the latest innovations is an interest-only mortgage; the principal is not repaid until the mortgage matures or is refinanced.

The product has carved out a niche in the U.S., where mortgage interest is tax-deductible, and was introduced in Canada in March by Mortgage Intelligence Inc., a mortgage broker and subsidiary of GMAC Residential Funding of Canada Ltd. It allows for lower monthly payments than would be the case on a traditional mortgage of the same size and, therefore, frees up cash that can be invested elsewhere or simply eases the financial pain of carrying a house. It also allows people to qualify for a more expensive home because of the lower carrying costs. One strategy would be to buy a house, carry it for a few years paying only the interest, then sell it — ideally for a handsome profit — and pay off the mortgage.

The disadvantage is that the borrower does not repay any principal and doesn’t build up any equity in the home. Over a long period, the interest paid to finance a home in this manner is substantially higher than on a mortgage in which the principal outstanding is reduced every year.

“The ability to take money that would normally go toward principal repayment and put it into other investments with a potentially higher return can be a big advantage to sophisticated investors,” says Lee Goderstead, president of Mississauga, Ont.-based Mortgage Intelligence. It may also be welcomed by people whose income doesn’t arrive in a regular monthly stream, he adds. “When an annual bonus or commission check comes in, the principal can be knocked down with a lump-sum payment. Up to 20% of the value of the mortgage can be prepaid each year.”

An interest-only mortgage has similarities to a line of credit secured by a home, except the interest rate charged by Mortgage Intelligence is fixed and the monthly payment does not fluctuate.

The rate charged is half a point higher than the going rate for regular fixed-rate mortgages, but there are no additional fees or insurance costs. The mortgage requires a down payment of at least 20% of the value of the house and, Goderstead says, the company is a little more cautious in the application process than with other mortgages, to minimize its risk. Normally,
with traditional lenders, a down payment of less than 25% is classified as a high-ratio mortgage and requires the borrower to pay for mortgage insurance to protect the lender, but the insurance is not required by Mortgage Intelligence. If the client wanted to put down less than 20% of the value of the house, he or she might qualify for a second mortgage, but it wouldn’t be interest-only and would be at a higher interest rate, Goderstead says.

Warren Baldwin, regional vice president of T.E. Financial Consultants Ltd. in Toronto is cautious about the interest-only option. It may encourage people to buy homes that are too expensive for them, he warns. If conditions change after a few years and they lose their jobs or are forced to sell their homes, they will have built up no additional equity in the home.

“If an interest-only mortgage is used as a
tool to shoehorn people into a property that is on the marginal side of what they can afford, it may get dicey if the real estate market heads south or their income suffers a reversal,” he says.

An interest-only mortgage certainly makes it easier to carry a house because lower monthly payments can be substantial. For example, a $300,000 traditional mortgage amortized over 25 years at 4.5% would cost $1,660 a month to carry, including a blend of principal repayment and interest. An interest-only mortgage at 5% could be carried with monthly payments of $1,250, resulting in a monthly difference of $410 or an annual difference of almost $5,000. If the savings are invested at a healthy rate of return, the gains after a few years could mean there’s more money available to pay down the mortgage with a lump sum than would have been paid off by making
principal payments.