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By Jay Schock
Interest-Only Mortgages, the hype:
The lure of easy money is ever present and always tempting to investors. In these days of relative uncertainty in other markets, real estate has become an increasingly popular investment option.
Many Americans look at their home as an investment as well as a place to hang their hat; and why not? In most markets, real estate has outperformed all but the most risky stocks for the past ten years. Though the trend is largely a positive one, the resulting increase in housing prices isn’t exactly problem-free. For example, some homeowners may find it difficult to afford to step up to larger homes as their families grow. In addition, some investors may find it difficult to obtain enough rental income to cover their mortgage payments.
Enter the latest catch-phrase in mortgage jargon: the interest-only mortgage. It seems that every television and radio advertisement is promoting interest-only mortgages. In fact, according to http://www.loanperformance.com (a mortgage monitoring unit of First American Real Estate Solutions), interest-only loans accounted for almost 40% of home purchases and a third of all private mortgages in California through April of 2005, up from 1.4% five years ago.
Are these mortgages as good as they sound or too good to be true? I’ll give you the facts and you can decide for yourself if interest only mortgages are really for you.
Interest-Only Mortgages, the facts:
First of all, there is no such thing as an interest-only mortgage. Interest-only is an option that can be attached to any number of loans, including fixed rate, ARMs, etc…
How they work:
Let’s say you are looking to purchase a home for $250,000 and put 20% down, leaving you with a mortgage of $200,000. At 5.50% on a standard, fully amortized 30-year fixed mortgage, your principal and interest payment would be $1,135.58. If you chose an interest-only option, the payment would drop to $916.67, a savings of $219.18 per month or $2,630.20 per year. Sounds pretty good, right?
Using the example above, if you attached a five year interest-only option to this standard 30-year fixed mortgage you would only be required to pay the interest on that mortgage for the first 5 years; however, after the five years have passed the principal balance would still be $200,000 (because you were only paying the interest for the first 5 years). The $200,000 would then be fully amortized over the remaining twenty-five years, resulting in principal and interest payments of $1,228.17.
Interest-Only ARMs:
Interest-only options become more risky when added to an ARM (Adjustable Rate Mortgage). If we look at the above example of the $200,000 and use a five year ARM (interest-only for the first five years) at 5.00% the interest-only payment is $833.33. After the five years have passed, not only does the loan become fully amortized over the remaining twenty-five years, but the rate can adjust as well. It is possible (depending on the type of five-year ARM and market conditions) for the rate to go up by as little as zero or as much as 6.00%. For our example we’ll use an increase of 2.00%. The increase of 2.00% coupled with the full amortization of the loan results in a new mortgage payment of $1,413.56.
Pay-Option ARMs:
Another popular product being used in conjunction with the interest-only option is the pay-option ARM, which allows the borrower to choose from three standard payment options as follows: (1) the standard, fully amortized payment, (2) the interest-only payment, or (3) a “minimum” payment. The minimum payment is generally based on a lower interest rate, which is sometimes advertised as low as 1.00%. If the borrower elects to make the minimum payment, the difference is added to the principal, resulting in a negative amortization. See the graph below:
As you can see, if a property fails to appreciate as expected, a person could find themselves in an “upside down” loan situation, meaning that they owe more than the home is worth.
Who Interest-Only Loans Can Work For:
Interest-only loans can work well in some situations. For example, if you know you’ll receive a year-end bonus from your employer you could take advantage of the lower, interest-only payments throughout the year and make the lump sum principal payment at the end when your bonus comes in.
Investors may use the interest-only payments to help with rental property cash flow; however, there is some risk in relying solely on the appreciation of the property for income. Investors should thoroughly research their properties before deciding whether an interest-only option is right for them.
ARM loans with interest-only options can work for those borrowers who are confident that they will own the property for a limited period of time. A good example would be the purchase of a starter home with intent to do quick renovations to build equity and sell within five years.
The Bottom Line:
When taking on a mortgage of any kind, especially one with an interest-only option or any other unusual product, exercise due diligence and make sure that you understand all aspects of the loan. Asking your loan officer the proper questions upfront can save you a lot of problems in the future.
Loans with interest-only options can work for the disciplined borrower in the right situation. They are certainly not for everyone. Home prices have been consistently on the rise, but there is no guarantee that they will continue in this direction.
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