For example, a 30-year fixed rate mortgage of $100,000 at 6 percent has a monthly payment of $599.56. This is the fully amortizing payment -- the payment, which, if maintained over the full term of the loan, will just pay it off.

In month 1, that payment divides into $500 of interest and $99.56 of principal. In month 2, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After five years the balance is $93,054. That is how mortgages amortize.

Now lets attach an interest-only option to this mortgage, available, say, for the first five years. That means that the borrower need pay only $500 a month during the first five years. There is no payment to principal.

If the borrower exercises the option, the balance after five years is $100,000. There is no amortization. Beginning year 6, the borrower must begin paying $644.31. That is the fully amortizing payment for a 6 percent loan of $100,000 for 25 years.

Misperception 2: It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.

Suppose a borrower takes the mortgage described above with the interest-only option, but decides to pay $599.56. He doesn't exercise the option but makes the fully amortizing payment instead. Then the loan will amortize just as it would have if the interest-only option had not been attached. After five years, the balance will be $93,054. If you make the same payment on the same mortgage, you end up in the same place.

If the borrower pays $700 a month instead of $599.56 on the same mortgage, the balance after five years will be $86,046. Whether the mortgage did nor did not have an interest-only option will matter not a whit.

Misperception 3. An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.

The notion that interest-only loans have lower rates arises from comparisons of apples with oranges. Adjustable rate mortgages (ARMs) with an interest-only option have lower rates than fixed-rate mortgages (FRMs) without an option. But an ARM with the option does not have a lower rate than the identical ARM without it.

Since the interest-only option is available on both FRMs and ARMs, it is pointless to be sucked into an ARM because of that feature. First choose whether or not you want an ARM or an FRM. This decision should be based on how long you intend to have the mortgage and on your capacity and willingness to accept the risk of a future increase in the interest rate in order to have a lower rate in the short-term. If you opt for an ARM, then select the other ARM features you want, including an interest-only option.

Misperception 4. On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period.It is not. This is the most dangerous misperception of all because it can induce borrowers to take ARMs that don't meet their needs.

The interest-only period is the period during which you are allowed to pay interest only. The period for which the initial rate holds is a different matter altogether. On an ARM with a very low rate, the interest-only period is always longer than the initial rate period.

A common ARM today has an interest-only option for 10 years, but the initial rate holds only for six months. On a $100,000 loan with an initial rate of 4 percent, the interest-only payment is $333. If the rate after six months goes to 6 percent, the interest-only payment would jump to $500. Borrowers who thought they were safe for 10 years would get a rude awakening.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

Copyright 2003 Jack Guttentag