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From: MortgagePro news - http://www.mortgagepronews.com/articles/June0433.htm
*** The Intrigue of the Interest-Only Mortgage ***
In the days leading up to the spring
closing date on Jonah Davenport's two-story
condominium in Columbia Heights, he and his
fiancee were growing increasingly anxious about
their upcoming $2,600 monthly mortgage payment.
They were discussing cutting back on their
wedding, scaling down their honeymoon and
renting out their second bedroom.
Then they found out about an interest-only loan.
Two days before closing, Davenport was able to
switch to a five-year, interest-only,
adjustable-rate mortgage (ARM) from a 30-year,
fixed-rate loan. The change saved him about $700
a month, decreasing his payment to a relatively
affordable $1,900. "This way, we could have
money in hand to actually live," he said. "We
have a lot more flexibility."
As home prices climb, many buyers are turning to
interest-only loans to reduce mortgage payments
and gain more financial freedom. But some
experts caution that there are home buyers who
don't fully understand the risks and don't
possess the fiscal discipline needed to handle
such loans.
The idea behind an interest-only loan is simple:
Borrowers are not required to pay down any
principal for a fixed number of years. For
example, on a 30-year mortgage with a five-year
interest-only ARM, the borrowers would pay no
principal for the first five years. For the
remaining 25 years, they would have
significantly higher payments, compensating for
the first five years. Interest-only options are
also commonly offered for a 10-1 ARM or for a
monthly adjustable rate. With a 10-1 ARM, the
interest rate is fixed for 10 years, then
adjusted every year thereafter.
The biggest upside to an interest-only loan is
the smaller payments. The downside is that
homeowners are building equity by appreciation
only -- not by paying down the principal.
Depending solely on appreciation, homeowners
could be left without much cushion if the market
stumbles.
If the market shifts and they must sell their
house for less than they paid for it, those with
interest-only loans will have no equity and will
owe the bank the difference. Even if there has
been some price appreciation, selling costs such
as real estate commissions could wipe out any
profit.
"There are bear markets in housing just like
bear markets in stocks," said Ruth Hayden, a
financial consultant based in St. Paul, Minn.
"In the short run, banking on appreciation is
risky."
Interest-only loans are not a new idea. In fact,
such loans were standard during the boom market
of the 1920s.
When the Great Depression hit, however,
foreclosures skyrocketed. That economic disaster
made the long-term amortized mortgage -- the
30-year loan with a gradual pay-down of
principal -- the U.S. favorite. Until recently,
in this country interest-only was an option used
only by real estate investors.
But as home prices have skyrocketed in recent
years, banks have started to sell interest-only
packages to mortgage brokers for consumers. In
most cases, customers pay a slight interest-rate
premium for an interest-only option, anywhere
from 1/8- to 1/2-percentage-point above the same
loan with standard amortization. Banks also
require higher credit scores to reduce the
increased risk of an interest-only loan.
Mortgage brokers say interest-only loans have
really taken off in the Washington area in the
past 18 months, after the dramatic price
appreciation here. "There's a direct correlation
with house values," said David Auer, president
of Universal Trust Mortgage Corp. in Pikesville,
Md.
For many local mortgage companies, interest-only
loans make up an ever-increasing share of their
business. Mark Townsend, president of Townsend &
Halbrook Mortgage Corp. in Rockville, said half
of his transactions are now interest-only. Fundy
Kasuri, senior mortgage banker at Buckingham
Mortgage in Tysons Corner, estimated that
interest-only loans make up about a quarter of
his business.
Financial planners agree that for homeowners
with lots of assets, interest-only loans can be
wise. There are no prepayment penalties on
interest-only loans, so homeowners always have
the option of paying down the principal. Having
other savings or investments available would
help absorb the shock if a homeowner had to sell
at a loss.
Thomas C. Grzymala, a certified financial
planner and principal at Alexandria Financial
Associates Ltd., was so impressed with the
concept that he got an interest-only loan for
his new semi-retirement home on a
Charlottesville golf course. Grzymala said he
would have been able to afford the house anyway,
but thinks he can make more money without a
principal payment.
"Being a professional money manager, I can do a
little better," he said. "I can take that
difference and use it for other purposes."
The popularity of interest-only loans also
reflects the realization among many buyers that
they will never actually own their homes.
Nationally, less than half the people with
30-year mortgages stay in place long enough to
pay off that loan.
Tim Meinhardt used an interest-only loan three
years ago, when he moved into an $800,000 house
in Rockville's Manor Park from a smaller home in
that neighborhood. When he recently refinanced,
he continued with the interest-only option,
preferring to invest the money rather than pay
down principal. "We don't have any intention of
paying the house off," he said. "All we wanted
to do was get the lowest monthly payment."
In addition to the wealthy, interest-only loans
are often recommended for people who fall into
three other categories.
The first are those whose income will jump, such
as medical students. The second are those who
are confident of their home appreciation, such
as Davenport, who will soon have a new Target,
movie theater and Giant supermarket within
blocks of his Columbia Heights condo. The third
are those who know they are staying for only the
short term, meaning they wouldn't pay down much
principal anyway and will move before the
interest-only period is up.
Take Eric Mauro, district security manager in
Laurel for United Parcel Service Inc., a company
known for frequently moving managers. When he
was transferred to Maryland from Buffalo last
year, he received a rude awakening in house
prices. Thanks to UPS stock and an interest-only
loan, though, he was able to afford a
3,700-square-foot, five-bedroom house in
Ellicott City. "Potentially, I could get
relocated every couple of years," he said. "You
do it this way, you get a bigger bang for your
buck."
Another category of homeowners, however, worries
some financial planners. Those are the people
who don't have many assets and who couldn't
afford their house except for an interest-only
loan.
"Don't agree to stretch your mortgage out to the
limit to buy a more expensive home," said Keith
T. Gumbinger, vice president at HSH Associates,
a New Jersey financial publishing firm.
Gumbinger said such homeowners often intend to
save money that would have gone to principal but
have trouble following through. "A lot of people
will go out to dinner or go out and buy a boat
instead," he said. "You can do better, but will
you do better? It's: 'Borrower, know thyself.' "
Grzymala, however, believes that interest-only
loans are right for almost anyone who can
qualify for one, even if that means moving into
a house that they couldn't otherwise afford.
With the tax deduction for mortgage payments and
the current appreciation rates, he said,
"interest-only loans are a very, very good
opportunity for people who can't afford the
whole enchilada."
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