As published in Scotsman Guide's Residential Edition, July 2005.
It seems as though everyone has an opinion on interest-only loans. These loans inspire discussion from a variety of perspectives, from borrowers to brokers to lenders.
An interest-only loan is not a type of mortgage. Rather, it is an option added to a mortgage. An interest-only loan allows a borrower to pay only the interest — or the interest and as much principal as the borrower chooses — in any given month during an initial time period.
Interest-only loans were the loans of choice in the 1920s, and borrowers were allowed to refinance at term. During the Great Depression, however, many of these loans faced foreclosures. From then on, wary lenders only wrote these loans in the most-extreme circumstances. As a result, today’s interest-only loans are for a specified period, often five to 10 years. At the end of the interest-only period, the payment goes to the fully amortized level, which makes the new payment larger than if the loan had been fully amortized at the outset.
Although many say interest-only loans are not ideal, these loans do serve a particular market segment. For someone with fluctuating income, an interest-only loan’s flexibility can be convenient. It keeps payments at a more-affordable level, when necessary. Once borrowers receive a bonus, they can make a substantial payment to the principal and recast the loan. Additionally, for borrowers who do not plan to keep their houses for extended periods, these loans help to keep payments low.
Unfortunately, many borrowers select the interest-only option because it allows them to qualify for a larger loan amount than normal. These borrowers are not building equity, so when their interest-only-loan period ends, they face high payments and few options other than to refinance or sell.
Market demand has caused lenders to react strongly to the interest-only option. In the past five to 10 years, there has been a direct correlation between the state of the housing market and the popularity of interest-only loans.
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