As I mentioned in my last post, some of the pre-recession “creative” financing options that went away after the recession are now making a comeback. Another one of those options that we’re starting to see again is the interest-only (IO) loan. It’s not as prevalent as the ARM, but it is rearing it’s ugly head in residential financing. Why in the world would anyone want to get an interest-only loan? Isn’t the point of home-ownership building equity and security? An interest-only loan can be a viable alternative in very specific situations and if you meet several criteria.
To put i/o loans in historical perspective, interest-only loans were popular in the 1920s when home buyers wanted to free up cash to invest in the stock market. When the 1929 crash came, scores of foreclosures bankrupted the i/o home buyers. In the early 2000s interest-only loans were popular with home buyers who wanted to be able to afford the monthly payment for a home they couldn’t afford. When it came time to make the principal and interest payments and borrowers couldn’t qualify to refinance their loans, scores of foreclosures bankrupted i/o home buyers. See a pattern here? Just something to keep in mind as we explore this option.
First, the “good news”: i/o loans increase house affordability by 20 percent. If you qualify for a $250,000 loan, you now can get $300,000; $300,000 becomes $360,000; and $400,000 becomes $480,000. In other words, you can qualify for a more expensive home than you would with a traditional mortgage. And the payments are dramatically different. On a five-year interest-only loan at 3.875%, your payment is $1,615. On a five-year hybrid at 3.750%, your payment jumps to $2,316. And on a 30-year fixed at 5.750%, your payment $2,918. Quite a difference there.
How interest-only loans work:
Interest only loans do not prohibit you from paying down the principal balance. Most are available only with adjustable rate mortgages. Most are five, seven or ten year interest-only periods, where the rate is fixed. After the initial period, the rate can rise up to six percentage points. For instance, a 5/1 ARM rate is fixed for five years and the i/o may only be for five years, and the next 25 would be traditional principal plus interest—greatly increasing your payment. After the initial interest-only period, the loan becomes a fully amortized 30-year mortgage loan with no pre-payment penalty.
Now for the (potentially) bad news. The payment differences break down as follows over the life of a five-year interest-only ARM:
Years one through five at 3.875%, your payment is $1,615. Years six through eight at 6.875%, your payment is $2,864. Years eight through ten at 9.875%, your payment is $4,114. Years 10 through 30 at 9.875%, your payment is $4,783. This last jump is due to the fact that during the last 20 years of the loan, the principal is spread out over 20 years as opposed to the traditional 30.
You may want an i/o if:
- You’re disciplined with money
- You’re something of a risk taker
- You’re not taking on more than you can handle comfortably
- You expect your income to rise sharply in the next five years
- You have an irregular income (like commissioned sales) so that the lower payment is manageable during lean periods and when the money is coming in can pay down the principal
- You’re content to let rising markets build your equity for you
- Home prices continue to rise
You don’t if:
- You have a lot of consumer debt that you can’t get a handle on
- You plan on being in your house longer than the interest-only period
- You’re undisciplined with your finances
- You’re borrowing a small amount (the savings might not offset the loan’s greater risk)
- You plan on spending the extra cash on “discretionary” items (your overall net worth will suffer)
- You plan to sell or refinance before the interest-only period ends
- You want to lock in today’s low interest rates
Before the great recession, many borrowers with long term plans were told they could take advantage of the interest only loan and then refinance out when it came time to make the higher principal and interest payments. The problem was that many people were not able to refinance out for a variety of reasons. When monthly payments went up, many borrowers could no longer make their payments. As a cautionary note, DO NOT assume your income will increase by the time the monthly payment increase or that you can refinance into a traditional fixed mortgage at any time. In general interest only loans are not the ideal financing product for the vast majority of borrowers. There are some specific circumstances and borrowers that are a great match these loans. Be sure to discuss your situation and future plans with a trusted lender when considering an ARM.