The scenario given to justify an "interest-only" loan is bogus:

For example, a Wall Street banker who has a relatively modest salary but expects a large bonus at Christmas may take out a pay-option ARM, start out by making interest-only payments, and then address the principal after the holidays.

Once principal payments kick in, they have to be paid month after month. If the banker cannot afford them on his modest salary before the bonus, he won't be able to afford them for very long after his bonus, either -- especially if he wasn't capable of saving his previous year's bonus. (And if a bonus is not truly expected every year, he has no business making it part of the basis for his mortgage.)

On Wall St bonuses can pay down most or all of the mortgage, if so applied. There's a reason luxury car ads shoot up around January and February in the WSJ/FT.

Option arms don't have forced principle repayment for 5-10 years depending on the loan. So a wall st/hollywood hot shot (for whom the loans were created) will have several large income events (bonus or movie release) and will have had the ability to have paid down most of the principle with their infrequent income.

A better use for Interest Only loans would be investors who's main concern is maximizing their monthly cash flow on a rental. Unfortunately, most people that took out interest only loans were doing so to take advantage of the rapid appreciation of the previous 8 years. Many didn't see the inherent risks because they believed the National Association of Realtors slogan that "Real estate always goes up".

What I find amazing is that while the pols are all stumbling over each other to be the one most critical of commodities speculators for supposedly driving up oil prices (there's some of that in there, but global demand has also been a huge factor), nobody seems to be willing to say boo about the flippers who helped to drive housing proces beyond affordability in the bubble markets, and think that propping up unaffordable prices in housing is somehow "looking out for the little guy".

nelsonal:

On Wall St bonuses can pay down most or all of the mortgage, if so applied. There's a reason luxury car ads shoot up around January and February in the WSJ/FT.

Option arms don't have forced principle repayment for 5-10 years depending on the loan. So a wall st/hollywood hot shot (for whom the loans were created) will have several large income events (bonus or movie release) and will have had the ability to have paid down most of the principle with their infrequent income.

Such people should neither take nor be given mortgages. They should save their bonuses for a few years and then purchase their home with cash.

Most of them are borrowing for the tax deduction/low interest funds anyway. Large downpayments and pristine credit are always required. Only a fool turns down an exceedingly profitable customer (they pay higher rates, keep high balances (no ammortization schedule), they also default less than other loans). Golden West figured this out decades ago, and built up a very nice business because most bankers thought agreed with you until the bankers did a 180 but forgot the important requirement of a large infrequent income part of the loan.

Hmm, I guess the US mortgage market is totally different from the rest of the world.

In Australia, 'interest only' loans on investment properties is the norm, and there is nothing 'exotic' about it. There is no point in paying down the principle as the investor intend to sell the property later on, and the loan have a maximum duration of 5 years. On the other hand, investment loans only lends out 70% of the value of the property, as oppose to 90% for normal housing loans. If a lender who allow 'interest only' loans on 90+% of evaluation, they are behaving recklessly.

It more or less started out that way in the U.S. Then we ran into a combo of reduced regulation (which all the pols who now want to point fingers of blame were heralding as a great advance in making homeownership more accessable at the time) and a rising market which many of the mortgage lenders had an interest in fueling because of the structure of their business.

In order to keep demand going (and prices rising), these loans were sold to some homeowners with lower and lower down payment requirements, since the down payment was a big obstacle to many potential buyers in a country with a near-zero to negative savings rate, going through "hybrid" loans where the borrower was loaned 20% as a consumer loan or even a HELOC and 80% as a traditional mortgage, then progressing into the Option-ARM loans (up to 100% financing), teaser loans, interest-only, and even negative amortization loans (where the sceduled payments didn't even cover the interest for a period of years).

Also, in some of the bubble markets, the vast majority of buyers were actually investors after a certian point. It was reported that in CA, option-ARMs and other exotic loans made up 60%+ of loans and around 90% of mortgages issued in the state in 2004 were to buyers who were purchasing a second home; there was no statistcal category for speculation in these lists, but I'd guess that almost all of those were looking to flip the houses they were buying since prices had been rising as much as 40% per year at the time, and some areas had tripled in price between 2001 and 2004.

If used responsibly, interest-only mortgages are useful. There are two factors at play: The first is that a fixed principal decreases at the rate of inflation. $100,000 now is worth more than $100,000 in five or ten years. On the other hand, rent will usually increase. The second is that young people starting out in life often have a lot of short-to-medium term debt, and a low starting salary with reliable increases.

That being said, they haven't been used responsibly.