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| | BobVila.com > Channels > Finance > All Articles > Interest-Only Mortgages
Interest-Only Mortgages
As housing prices have soared nationwide, affordable housing has been redefined by borrowers and lenders. New products, like the interest-only (I/O) option loan, are springing up in response to consumer demand.
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Lenders are offering products that help buyers ease into home ownership in tough housing markets. It’s important to understand what these options mean and whether they benefit the borrower in the long run.
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Interest Only Loans
With an interest-only feature, payments on the principal are temporarily left to the discretion of the borrower. It’s an offering that seems to tip on its head the idea of building home equity. If you aren’t paying on the principal, you are not building ownership in the house. But homebuyers in California, the District of Columbia, Virginia, Arizona, and other areas where prices have risen dramatically, are using it to get the homes they want.
The details of interest-only options vary by lender. Many are offered on adjustable rate mortgages (ARMS). With an adjustable-rate I/O loan, the interest-only period is typically five to ten years. But, because it is an ARM, the loan will see periodic rate adjustments. The interest rate might be reset on an annual basis, increasing or decreasing interest payments each year. The fully amortized payments—where principal and interest are figured into incremental payments to pay off the loan—could also change each year.
Fixed Rate and Adjustable Rate Loans
A fixed-rate interest-only mortgage also allows for interest-only payments over first five to ten years followed by a set schedule of fully amortized payments. Since the interest rate is fixed, there are no surprises when the remaining principal and interest payments are recalculated.
A hybrid I/O could offer fixed payments with an adjustable rate. These loans offer an initial fixed-rate, interest-only payment period of five years. At the end of five years, payments rise and fluctuate with changes in the interest rate.
Data is showing that more borrowers are opting for the interest-only loan feature. LoanPerformance, which compiles and analyzes mortgage finance data, says the percentage of I/O mortgages doubled in less than two years. It is even growing as an option among those refinancing existing mortgages.
Loan Eligibility
Lenders look at every aspect of a borrower’s profile to determine eligibility for any loans, including those with an interest-only feature. As with traditional loans, lenders review income, debt, credit score, and security of the home before making a decision. But just because a loan product is available doesn’t mean it’s right for all borrowers.
“When people see a lender in the home-buying process, they learn not just how much they can get but, more importantly, how much they can afford to pay,” says Michael Fratantoni, senior director for research at the Mortgage Bankers Association. People need to know all of their borrowing options, but lenders’ products are not “one size fits all.”
When an Interest-Only Option Makes Sense
Experts suggest the interest-only feature may be appropriate in several borrower situations. A person who counts on getting large periodic bonuses may like this option as he or she can apply that money directly to the principal. The borrower must be disciplined enough to follow through when the bonus arrives.
Other borrowers prefer to make monthly payments into investments—rather than to principal—with the assumption that the investments will offer a higher return than the cost of the loan. Borrowers who are confident that their personal incomes will grow may choose the interest-only option, figuring that their rising salaries will let them grow into the later principal and interest payments.
Borrowers who are confident that the values of their homes will soar over the next several years may also select the interest-only option. They may hold onto the house just long enough to pull the growth equity from it when it sells, having avoided large payments while the equity grew. Some borrowers may plan to refinance later at a lower fixed rate once their equity has grown and the home’s value has increased.
Borrower Beware
There are those for whom this option might not be good. Joe Rogers, an executive vice president with Wells Fargo Home Mortgage, says interest-only would not be recommended for those borrowers who can barely afford the house they are in, those who have tendencies to shop compulsively or are free spenders by nature, or those who are buying in a market where home values are declining.
Rogers says the interest-only feature “helps consumers manage their home financing payments and build equity at their own pace, thus allowing them to redirect cash flow to maximize investment and savings contributions. As customers make principal reductions, this also reduces their monthly payment requirement—unlike a fully amortizing loan—and is a key feature of an interest-only loan.”
Understand the Loan Climate
The interest-only loan is only a feature on a mortgage that will, eventually, require that interest AND principal be paid in full. Private mortgage insurance may be required or possibly built into the payments if a homebuyer does not have 20 percent to put down. If the option is offered on an ARM, borrowers need to understand that the interest rates will be changing and their interest-only payments may go higher.
If the housing market takes a downturn, borrowers may be stuck with a large mortgage on a house that will no longer sell at that price. If they had to move, they would be stuck with finding additional money to pay off the mortgage. Investment income and prime lending rates may also fluctuate, which will affect the desirability of an interest-only option.
The National Association of Realtors sees the growing use of interest-only and other unusual loan products as a threat to home ownership. NAR President Al Mansell says there are “insufficient disclosures” being made by lenders on these “riskier loan products.” The Association plans to offer consumers an educational brochure about various mortgage products. Mansell advises consumers to seek out reputable third-party consultants, such as the Better Business Bureau, for information on lenders and loan products.
Text by Maureen Blaney Flietner
Copyright BobVila.com © 2005
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