Question: Consider the following situation: An investor who needs a long-term mortgage to finance a property acquisition is trying to decide between two loan contract proposals.
Loan #1 is a 10-year term, 20-year amortization loan.
Loan #2 is a 10-year term, interest-only loan.
The investor is confused because both the upfront fee and contract mortgage rate are slightly higher with the interest-only loan compared to the partial amortization loan. He feels this is backwards since with the interest-only loan, his debt service payments are smaller, which implies a higher debt service coverage ratio for the lender and hence less risk. Is the investor correct? Explain your answer.