The Tempting Interest Only Loan
RISMEDIA, July 20 – This article is the first in a series of informational articles dealing with
various aspects of the mortgage industry, dubbed “Mortgage 101”. Throughout the series
we’ll examine various types of loans available to home seekers, as well as cover other
pertinent mortgage related concepts, because an informed agent is an asset to their client.
This week we’ll be discussing the merits and more dubious pitfalls of the “Interest Only”
loan.
“Principal Deferred” Loans
The “Principal Deferred” Loan – commonly called the “Interest Only” Loan – isn’t new, but
it is the single fastest growing segment of the mortgage industry today, and it’s not hard to
understand why: interest rates remain low while home prices continue to climb.
In essence, these loans allow potential homebuyers to defer principal payments for a
certain time period. Borrowers can select a two, three, five, seven, or ten-year adjusted
rate mortgage (ARM), with a five or 10-year “Principal Deferred” option to maximize cash
flow; the idea being that buyers can then use the “deferred” principal money they aren’t
paying on their home to pay off higher interest-revolving debt, such as credit card debt,
automobile loans, etc.
A Simple Cost/Benefit Analysis
The benefits to this type of loan are twofold. First, they create a manageable monthly
payment for homebuyers during the deferment period. Second, they enable borrowers to
leverage cash flow to acquire additional property in an escalating market.
The monthly cost to own a home may be lower initially, but the backend of a “Principal
Deferred” loan can be treacherous. For example:
• A $232,000 ARM loan @ 5.6250% with a five-year “Interest Only” option requires a
payment of $1,087.50 during the first 60 months. On the 61st month, the payment will
increase $722.37, for a total of $ 1,808.87. Let’s say interest rates rise 2.5% during the
first five years. Payments will correspondingly ascend to the payment cap. A fixed rate
mortgage (which is locked against market fluctuation) will increase $354.55 for a total of $
1,442.05.
The risks are also twofold. When rates inevitably rise, handling a higher payment can
prove too difficult on a fixed income. Couple that with a broad flattening of appreciation,
and payments end up feeling more like “rent” with limited returns than the appreciating
asset a homeowner borrowed money to purchase in the first place. Life has a way of
keeping us on our collective toes, and any major financial event – such as a lost job,
sudden health issue, death, divorce, college, wedding – can cripple those who have
decided to go the route of the “Interest Only” loan.
Avoid the End of Deferment Trap
At the conclusion of the deferment period, lenders begin to require payment toward
principal along with the interest to eliminate the debt. At this time homeowners begin to
pay off the actual loan amount they borrowed. Everything paid up until this time was
interest, or put another way – the money a homebuyer pays a lender for the right to
borrow his/her money. A steep payment increase could force you to refinance into
another “Principal Deferred” loan at a higher loan amount (incurring additional expenses).
Otherwise, if the payment shock is too much for your budget, you could sell your home,
incurring transaction expenses, or lose it through foreclosure.
Banks will foreclose on property that has increased in value if homeowners are unable to
meet their monthly obligation or re-qualify for a new loan. It then becomes that much more
difficult to qualify for another loan, especially if homeowners are generating the same
income while interest rates rise. Monthly debt-to-income ratio may prevent them from
qualifying for a new loan if they exceed the percentage limit permitted by their lender.
Many borrowers mistakenly link the expiration of a “Principal Deferred” period with the next
rate adjustment of an ARM. If ill planned, this blunder can cost thousands of dollars in
refinancing expenses and an unexpected jump in your monthly payment.
Fiscal Wisdom
Is an “Interest Only” loan right for you? It depends largely on two factors:
1. Your degree of real estate market savvy. If your understanding of the various economic
factors that influence the dynamic real estate market is paltry at best, you are a target for
the host of lenders who are more than willing to lend you their money. If you are
considering this type of loan, do so with extreme caution and full disclosure of the facts.
2. Your reason for buying. In a hot seller’s market, “Interest Only” loans can reap a
sizeable reward as a short-term investment, as you pay minimal monthly payments and
can turn around in 2-3 years to sell your rapidly appreciating home for a profit. However, if
you are considering obtaining this type of loan for a property that you intend to call
“home” for a long period of time, ready yourself for the formidable increase in monthly
payments once the deferment period ends.
While sound financial advice always returns in some way to clichéd common sense (never
spend more than you have, pinch your pennies, etc.), most Americans don’t have
hundreds of thousands of dollars sitting around with which to offer 100% cash for a home
purchase. In most cases, a loan is required. When it comes to the “Principal Deferred”
Loan, clearly identify your reasons for buying; keep a close eye on interest rates during
your deferment period; know the right time to sell, and do your best to create substantial
savings in the meanwhile.
Information provided by Jon Kitchens, a Mortgage Broker with Home Loan Express in
Bend, Oregon. Jon can be reached at 541-390-3378.
RISMedia welcomes your questions and comments. Send your e-mail to:
editorial@rismedia.com
Author: Beth Bresnahan
Publishing date: 07/20/05
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