Interest Only Loans: The Myths and the Risks

By: Henry Savage: RealtyTimes
The sustaining popularity of interest-only mortgage programs has created a lot of media attention. Henry Savage cuts to the chase and examines the interest-only product objectively.

It appears that most financial writers in the media have jumped on the Interest-Only Bandwagon, thanks to the immense popularity of these products. Most of what I have read in the media on the subject gives an overall pessimistic viewpoint -- a warning to those who are thinking of taking out an interest-only loan that they carry considerable risk.

I don't necessarily disagree with everything that is being written. I'm in this business every day, talking to buyers facing skyrocketing home prices and homeowners salivating over low interest rates and low payments. Let me give you my view.

Interest-only loans allow the monthly payment to be equal to only the interest charged for that month. The principal balance does not change. In contrast, a loan that carries a 30-year amortization requires a monthly payment that covers the interest charged, plus enough of the principal balance that will pay the loan to zero in 30 years.

The difference in payment is startling. An interest-only payment is lower by about 20 percent, regardless of how much you borrow. For example, a $400,000 loan with a 30-year amortization at 5.75 percent will cost $2,334 per month. An interest-only payment would only cost $1,917.

Looking at it the other way, interest-only loans allow a buyer to afford 20 percent more house. Let's say that your comfort level for a house payment is $2,700 per month. Subtract $400 for the real estate taxes and insurance, and we have $2,300 left to make the principal and interest (or just interest) payment. At 5.75 percent, a 30 year amortized loan would allow you to borrow $394,000. An interest-only loan would allow you borrow $480,000.

Interest-only loans, unfortunately, have become a necessary product for home buyers in some areas. Folks who are buying in areas with lofty home prices are stung by sticker shock.

The difference between borrowing $480,000 and $394,000 may offer a family an opportunity to buy a nice house, thanks to an interest-only mortgage.

For folks where affordability isn't an issue, an interest-only loan gives them the option of taking the lower payment and investing the difference somewhere else. Remember that paying down a mortgage loan is akin to investing the money in an illiquid asset that's earning the same return as the after-tax cost of the mortgage. A 5.75 percent mortgage rate, discounted by say, 25 percent for the tax deduction, equals a "cost-to-borrow" rate of 4.31 percent. That's cheap money. Proponents of the interest-only loan have a strong argument that investing the money elsewhere is wiser.

Now let's get to the question as to whether interest-only loans carry significant risk. As with anything else, it depends.

Remember that these loans give you merely the option to pay just interest. You are always free to plow money into the principal and pay it down.

Skeptics charge that the frenetic housing boom cannot be sustained. I wholeheartedly agree. In fact, I'm so pessimistic that I think certain areas in the country (including parts of the Washington, DC area, where I come from) could face home-price depreciation. But does that mean interest-only loans are risky? It depends.

The way I see it, there are four basic things to watch out for if you're considering an interest-only loan.

First, know the length of the interest-only term. If you take out a 5/1 ARM, for example, you will probably be allowed to pay only interest for the first five years. After that, you must pay off the loan over a 25-year amortized period. Plus, your interest rate could be higher.The potential result: severe payment shock.

Second, contrary to what I've read, make sure you plan to hold your home for a reasonable period of time -- at least five years. Some say an interest-only loan is appropriate for folks who plan on a short-term hold because very little principal is curtailed in the early stages of an amortized loan anyway. While this may be true, it's irrelevant. Real estate values appreciate over time, but they are indeed cyclical.

An interest-only loan can be dangerous if the buyer is solely relying on unreasonable appreciation expectations over the short term. Markets will turn. We just don't know when.

Third, make sure you are able to pay at least 10 percent down. If the market turns and your property value drops when you need to sell, you won't be left "upside down," meaning your mortgage balance is greater than your property's market value.

The way I see it, the biggest risk inherent with interest-only loans apply to the borrower who has a very small down payment, has a short holding period, and is using the interest-only feature to maximize his qualifications. Add to the mix unrealistic appreciation expectations and poor market timing, and there's likely to be some trouble.

The bottom line is this: Interest-only loans give the American consumer more choice. But choices go hand-in-hand with responsibility. Choose wisely.