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   ARTICLE   |   From Scotsman Guide Residential Edition   |   July 2005

Knowledge is key with interest-only option

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.

Clearly, housing has become less affordable, with prices spiraling higher and higher. An interest-only option allows first-time homebuyers to purchase a home that is approximately 20 percent to 30 percent more than what would be affordable with a fully amortized loan. Without a large down payment, this scenario can be extremely risky and cause borrowers problems with their mortgage payments.

Furthermore, the lower-interest-rate envi- ronment has been conducive to an interest-only-loan thought process. Why wouldn’t borrowers see the benefit in paying off a loan with such a low interest rate? It frees up cash for them to use elsewhere.

Existing homeowners also have used this option to refinance. Why bother paying off the principal when the property value is growing exponentially?

Lenders’ concern is that foreclosures are possible as rates increase and borrowers cannot afford their homes after the interest-only period. Loans of particular concern are those that are three-year fixed with three-year interest-only periods. With interest rates rising, these fully amortized loans can become adjustable, which causes payments to double. Some lenders will charge a higher rate for an interest-only option, as these loans carry a greater risk of default.

Some borrowers use the interest-only loan as a refinancing option to lower monthly payments. In fact, a borrower with a traditional 30-year fixed mortgage could refinance into an interest-only hybrid ARM loan simply to get payments as low as possible. Fluctuating income, investment of excess cash flow and a quick capital gain also can be solid reasons for selecting an interest-only option. Whatever the reason, interest-only loans can have a positive or negative impact, depending on the borrower.

It also is important to remember that interest-only loans:

  • Do not carry a lower interest rate; 
  • Do not allow the borrower to avoid private mortgage insurance;
  • Are not less costly to amortize; 
  • Do not mean the interest rate is fixed for the interest-only period.

Some argue that these loans prohibit borrowers from building equity in their homes. For the past 10 years, though, U.S. homes have been appreciating at a rate of 5 percent to 6 percent each year. Even if borrowers are not paying down the principal, they are building equity through appreciation. Some will argue paying down mortgage debt is the way to achieve wealth.

We all can relate to the dilemmas of the mortgage process. To avoid trouble down the road, we all must take the responsibility of educating borrowers and ourselves on the best loan options on a case-by-case basis.

Whether or not an interest-only loan is the best fit, we must understand the needs of  borrowers and work with lenders to determine the best mortgage and options. 


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