Interest Only Loans

The explosion in home appreciation rates over the last five years has been a real boon to homeowners and an increasing challenge to home buyers, especially first time home buyers.  One of the by-products of this phenomenon has been a collection of “exotic” mortgage packages, one of which is the interest-only loan.

An interest-only loan is a version – an extreme version - of the adjustable rate loan, or ARM.  A typical thirty year interest only mortgage would allow the borrower to pay only the interest due on each monthly mortgage period for a fixed period of time; usually three to five years.  Thereafter, the borrower would be obligated to pay both principal and interest.  During both periods, the interest-only and the fully adjusted period of the mortgage, the interest rate adjusts periodically.

Interest Only Mortgage Rates - 5/1 ARMs for Refinancing:
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The purpose of these loans has been to allow people who cannot afford the monthly premium of a thirty year fixed rate loan to get into the housing market anyway, with initial loan payments at an artificially low level.  It has also had the effect of allowing people to borrow more money and buy more house than they could manage under traditional borrowing methods. ---Current interest only mortgage rates from lenders that compete for your loan.

And it has been a very successful financial product.  Since the product was introduced in 2000, the issuance of interest only mortgages has gone up about 20% every year and in 2005 close to one third of all mortgages issued were interest only loans.  It is also fair to say that because of the proliferation of these loans, there is a substantial amount of concern about an increased level of foreclosure now that the rapid appreciation of home values has come to a screeching halt.

These loans have enormous sticker shock when they adjust to the full premium amount.  A monthly mortgage payment can jump fifty, even eighty percent in cost.  Many people who get into these loans assume that they will be able to refinance in five years or whenever the mortgage is about to adjust; or they assume that household income will have increased sufficiently to manage the full mortgage payment.

The risk in an interest only loan is that by design, the new homeowner is not realizing any equity through the first few years of payments.  Any equity that develops will be through appreciation of the home.  If the housing market settles into a slump, it is entirely possible that a homeowner with an interest only loan may owe more on the house than it is worth when it comes time to refinance.  That makes refinancing impossible and foreclosure a real possibility if the homeowner cannot meet the adjusted mortgage payment.

Many people who get into interest-only loans lose sight of the fact that if they are paying just the interest for five years that leaves twenty five years to pay off the entire principal.  That is why the payments jump so precipitously; moreover, the interest rate is adjustable and will inevitably climb during the course of the mortgage.  That is why these mortgages are considered risks.  For some people, it is a calculated risk – they are planning to sell in five years, they have equity to put into the home, or they feel that investing what would be their payments on principal can get them a greater return.

Unfortunately, for many starry eyed home buyers interest-only loans are not calculated risks.  Many people simply do not understand the implications of the loan’s financial terms or assume that a solution will present itself when the time comes.  There is an inherent danger in buying a home as an investment, as so many have done during the recent housing boom.  Previous generations took out loans with the intention, and the ability, to make thirty years of payments.  For many of today’s home buyers, that has become an antiquated concept.

Source: Mortgage Lenders Plus.com