The Miracle Mortgage
How do you afford a home in a booming market? For many, the answer is a wildly popular new loan that is part blessing, part time bomb.
(MONEY Magazine) – Six months ago, Chris and Suzanne Bernier were just getting by. The couple's debt load had grown to more than $9,000 in four years as they relied on credit cards to fund a new camper, vacations and stuff for children Eryn, 16, Dylan, 13, and C.J., 3. Though they had already refinanced their mortgage--to a low 5.5% interest rate on a 30-year fixed loan--and consolidated their high-rate credit-card debt into a bank loan, they simply weren't getting ahead. "We were still living month to month," says Chris, 37, a desk officer with the county sheriff's department. But now, by paying only the interest on a 4.85% adjustable-rate mortgage, the Berniers have an extra $400 a month that they are using to whittle down their debt and build up their savings. And they are confident that they will be able to buy a new, larger home within five years. "We feel like we are finally on track to getting somewhere," says Suzanne, 36, a manager at a mortgage processing company. Chris agrees. "We've chosen to use the power of the interest-only loan for our own benefit."
Like the Berniers, tens of thousands of Americans have recently discovered the power of paying nothing but interest on their home loans. The appeal is easy to understand: When you don't pay down principal, you can save hundreds, even thousands, of dollars a month. Interest-only payments let you shoulder a bigger mortgage and buy a home you might not otherwise be able to afford. Or you can use the extra cash to pay down debts or fund a child's education.
Whatever the reason, consumers are finding the lure of lower payments hard to resist. According to mortgage data firm Loan Performance, nearly a third of home loans made last year nationwide included an interest-only option, up from almost none four years ago. In the hottest real estate markets in the country (particularly on the coasts) lenders say that as many as 70% of new loans are interest-only.
The problem: Those low payments don't last. Eventually, every interest-only mortgage converts to a regular one, and unless you sell or refinance before that time is up, you'll see a steep rise in your monthly payments. And because most IO mortgages are also adjustable, that increase could be doubly harsh if rates go up. "I think there is a day of reckoning coming for these loans in the hands of the wrong people," says Patricia Houlihan, a financial planner in Reston, Va.
Still, an interest-only mortgage can be a sensible choice at times. If you are tempted to grab one--or already have and wonder what comes next--read on to learn more about this hot loan.
HOW THE LOAN WORKS
What people commonly call an interest-only mortgage isn't one particular type of loan. Rather, interest-only is an option that can be attached to any mortgage. And in every case, after a certain time (usually five, seven or 10 years) the mortgage becomes fully amortizing, and you must pay both interest and principal. Because you're repaying the principal in 20 or 25 years, not 30, those principal payments are higher than they would have been.
Other than that, the terms are as varied as those on any other mortgage--anything from a one-month adjustable rate to a 30-year fixed. IOs generally have a slightly higher rate (about a quarter of a percentage point) than the same loan without the interest-only feature (one reason lenders like them). But for most borrowers, that's a small price to pay for the deep savings that interest-only payments represent.
WHAT CAN GO WRONG
The biggest problem is payment shock: Someday you will have to write a check to your mortgage company that's hundreds of dollars higher. Take a $300,000 interest-only ARM that has a fixed rate for five years and then converts to a regular one-year ARM. If the one-year rate is 6% (a typical rate over the past 15 years), your payment would go from $1,335 to $1,933.
Another minus is that you don't accrue any equity during the interest-only term. Yes, it's true that you pay mainly interest in the first few years of any mortgage. On a $300,000 traditional mortgage at 6%, for example, only $3,684 of the $21,584 you pay in the first year goes toward principal. But that quickly adds up. You'd have built about $21,000 of equity in five years, $50,000 after 10 years. "The attractive feature of amortization is that it's automatic and every month the savings go up," says Jack Guttentag, a Wharton professor who runs Mtgprofessor.com, a mortgage information website.
Of course, this torrid real estate market has seemingly eliminated the need to pay down equity. Many home buyers figure they can quickly reap huge equity gains simply by owning a house. An interest-only loan is a foot in the door. But wait: There's no guarantee that home prices will keep rising; you are essentially making a bet on your local market. Remember the $21,000 in principal you paid in the first five years in the loan example above? If you made a small down payment and housing prices stayed flat in your area during that time, that equity could make the difference between covering your closing costs and commission--or having to bring a check to the closing to pay off your mortgage.
WHO'S A CANDIDATE
Despite these cautions, interest-only mortgage payments can be a useful tool in certain situations.
» You can count on a higher income in a few years. Say you're a medical resident or a young lawyer and are confident that you'll get big raises well before higher payments kick in. Or you're a stay-at-home mom who plans to return to work full time when your kid hits kindergarten. An interest-only loan can help get you into a home now that will match your paycheck down the road. "There's no reason to put your life on hold and not move into the right home because of a temporary situation," says Ross Levin, a financial planner in Edina, Minn.
Similarly, interest-only loans can work well if you get a large year-end bonus or periodic commissions. Throughout the year your mortgage payments are low, and then you can pay off principal when the extra cash comes in. (Make sure your loan doesn't have a prepayment penalty.)
» You have a good use for your monthly savings. Alternatively, you may be able to afford a regular mortgage but would rather deploy the money elsewhere. With lower mortgage payments, you can pay down high-cost debts or meet a short-term expense such as college tuition. By saving for five months, the Berniers have already built an emergency cash reserve. The key for this scenario to work, says Levin, is that you must have the discipline to save or invest that extra money, not just use it to fund a high-flying lifestyle. "My biggest concern is that people are well-intentioned but don't actually set aside the money," he says.
» You know you are going to move or sell soon. If you don't plan to stay in your home for long--because of a job transfer, retirement or an expanding family--you won't build much equity anyway. But be careful if you are stretching to buy. You may find that it is difficult or even impossible to sell your home quickly if the market sours, leaving you with a loss or the prospect of payments you can't afford.
Serious real estate investors find interest-only loans especially valuable. Low payments let them buy more properties or make more money on the rent. "The point for me is to get in, fix it up and get out within two years," says Jay Williams, 34, a real estate investor in Atlanta who has bought three of his six properties with interest-only loans. But Williams, who has suffered real estate losses as well as gains, is cautious. "I only use interest-only if I'm investing in an area where I know the appreciation is strong," he says. "If I'm not sure what the market is going to do, I won't take a chance."
THE EXIT STRATEGY
What if you've already taken out an interest-only mortgage but don't plan to move any time soon? You need to keep in mind that higher monthly payments are inevitable, and you better have a plan. (Don't count on an easy out like low-rate refinancing; mortgage rates are near historic lows now and are more likely to be higher than lower when your interest-only term ends.) Instead, take the time to ask yourself some questions: Where would the money for bigger mortgage payments come from? What in your budget can you cut? Would you consider selling your home if you couldn't afford it? Alternatively, if you can write a bigger monthly check today, there is an easy out: Refinance into a fixed-rate mortgage. After all, with interest rates poised to rise, you're unlikely to find a better time to lock in.
More and more home buyers are taking out interest-only mortgages.
% OF NEW MORTGAGES THAT WERE INTEREST-ONLY
What's driving growth is ultralow mortage payments--at least at first.
INITIAL MONTHLY PAYMENT ON A $300,000 MORTGAGE AT RECENT RATES
NOTE: Year-six payment assumes 6% rate on one-year adjustable mortgage. SOURCE: HSH Associates.