Interest-Only Home Loans Pose Perils, Possibilities: John Wasik
July 18 (Bloomberg) -- Every overheated market offers opportunities for the smart and foolish to take a shot at earning easy money.
The U.S. housing market is the latest to tempt investors, more of whom are betting that they too can profit by using one of a variety of potentially risky loans.
These mortgages, including interest-only, no cash down or adjustables, offer the benefit of lower monthly payments. The downside is they can turn into financial traps if real estate prices fall or mortgage rates surge.
Even Federal Reserve Chairman Alan Greenspan is warning about these loans. He singled out the mortgages in testimony before Congress's Joint Economic Committee last month.
``The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other exotic forms of adjustable-rate mortgages, are developments of particular concern,'' he said.
The advantage of interest-only loans is they can lead to rapid building of equity from market gains while offering smaller monthly payments than with standard loans.
In markets with big jumps in housing prices, interest-only loans are not only favored by speculators and investors, they are making payments more affordable for homebuyers who ordinarily wouldn't qualify for loans.
Interest Only
Interest-only loans accounted for almost 40 percent of home purchases and a third of all private mortgages in California through April, up from 1.4 percent five years ago, according to loanperformance.com , a mortgage monitoring unit of First American Real Estate Solutions.
The national average is almost 20 percent for these loans, up almost 20-fold in the past half decade. In the most expensive markets, they are even more popular.
For homebuyers seeking lower monthly payments, interest-only loans have loads of appeal. Say you're considering a $500,000 jumbo mortgage with no points. You could pay $2,800 per month on a 5.5 percent, 30-year, fixed-rate loan and about $400 per month less on a one-year, adjustable-rate loan at 4.25 percent, according to bankrate.com , the rate quoting service as of July 13.
The payment could be as low as $2,000 a month using an interest- only loan. In this type of loan, the principal balances do not drop during a limited interest-only period, after which payments rise to cover both principal and interest.
Huge Difference
The lower payments make a huge difference in markets like California, where the median home price is $522,590 and the percentage of state households able to afford a home slid 3 percentage points to 16 percent in May, according to the California Association of Realtors.
New option adjustable loans may offer even lower payments, with initial advertised rates as low as 1 percent. As with all adjustable mortgages, the rate must be added to a ``margin'' of up to 2.8 percent to come up with the annual percentage rate. For this half- million-dollar loan, the payment for an option ARM would be $1,600, a 42 percent savings from the 30-year loan.
The downside is interest-rate and repayment risk.
One of the great hazards with an interest-only loan is when your home value declines. Then it becomes an ``upside down'' loan, meaning you would owe more than the home is worth. Should this happen, the buyer would be tempted to walk away from the home, saddling the lender with the depreciated property.
Spelled Out
Mortgage brokers sometimes neglect to spell out the terms of the rate adjustments. Here are some guidelines:
-- Ask about the ``margin'' of the loan, or the amount added to an interest rate index to come up with what you will pay. Generally, the lower the margin, the lower your rate. A typical margin is from 2.25 to 4 percentage points.
-- How often and how much could the payment increase? Some option ARM rates change as often as monthly with rate caps of 9.5 percentage points. Estimate how much of a payment shock you can afford to take. Keep in mind there are two caps on adjustables: One cap limits how much the rate can change during the life of the loan, while another governs how much the rate can change between adjustment periods.
-- The index used for the rate adjustments is also critical. If the five-year Treasury note is the basis of your rate, it's almost 60 percent higher than that of the shortest-term one-month Libor rate, although this index changes frequently. The ``Monthly Treasury Average'' index is among the indexes least likely to rise rapidly.
Hybrid Loans
For investors or those buying second homes, the option ARM presents some interesting possibilities. These loans also go under the names ``Pay Option ARMs'' or ``Cash Flow Option'' loans.
This hybrid allows you to choose what kind of loan structure you want, including a minimum, interest-only, 30-year or 15-year payment.
The principal you owe on this loan will eventually have to be repaid, though. The loans are usually ``recast,'' typically after five years, when the principal owed is added into a dramatically larger monthly payment.
A combination of rising rates and repayment of principal can easily trigger a doubling of the payment.
Disciplined Buyers
Alex Giassa, a personal mortgage consultant with First Interstate Financial Corp. in Paramus, New Jersey, says these loans can work for disciplined individuals who may want to buy vacation homes or investment properties and can make lump-sum payments to principal.
``An Option ARM may be good if you know you're going to get a bonus at the end of the year and can make a payment to principal,'' Giassa says.
``I'm usually saying no (to these loans) unless it's absolutely certain the client has a specific amount of time they'll be in the home that matches up with the loan,'' says Michael Dubis, a fee-only financial planner with Touchstone Planning in Madison, Wisconsin. ``The client also has to be aware that home prices can actually go down.''
While property appreciation is magnified by leverage, losses can balloon as well. There's nothing sacred about home values.
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