New fixed-rate, interest-only mortgage popular

As rising mortgage rates drive up the costs of buying a home, consumer demand has soared for a recently introduced type of mortgage that offers the security of a fixed interest rate but with relatively low monthly payments in the loan's early years.

So-called fixed-rate interest-only mortgages allow borrowers to lock in an interest rate for the life of the loan, while reducing their monthly outlays by paying interest and no principal, typically for the first 10 or 15 years. These loans, which barely existed two years ago, now account for roughly 8 percent of all new residential mortgages taken out, says UBS AG, a financial services firm. Borrowers took out roughly $39 billion of these mortgages last year, up from just $7.9 billion in 2004, according to UBS, which analyzed loans that are packaged into mortgage-backed securities.

The growing demand for fixed-rate interest-only mortgages underscores the adjustments borrowers are making as mortgage rates have climbed to their highest levels in recent years and the gap between short-term and long-term interest rates has narrowed. Rates on 30-year fixed-rate mortgages recently averaged 6.62 percent, according to HSH Associates in Pompton Plains, N.J., the highest since July 2002. The cost of adjustable-rate mortgages, which many borrowers have long relied on to lower their monthly payments, has climbed even faster. Rates on one-year ARMs average 5.81 percent, the highest since September 2001.

Banks are taking advantage of the new demand. U.S. Bancorp added fixed-rate interest-only mortgages to its product lineup in September. These mortgages now account for 8 percent of the bank's new mortgage loans and loan volume for the product "is growing every month," says Dan Arrigoni, president of its home mortgage unit. The Minneapolis-based lender has at times offered special lower rates to promote the loans, which allow for interest-only payments in the first 10 years of either a 20-year or 30-year fixed-rate mortgage.

At Quicken Loans Inc., an online lender, demand for the "Smart30" fixed-rate interest-only mortgage "has absolutely exploded" in recent months, says the company's chief economist, Bob Walters. "It's become our most popular program," he says. Meanwhile, originations of fixed-rate interest-only mortgages at GMAC Mortgage, a unit of General Motors Corp., increased fivefold between December and February. The company says first-time homebuyers have been the biggest customers for the product.