The Principal Facts of Interest-Only Mortgages
The Principal Facts of Interest-Only Mortgages
Step right up! Buy the house of your dreams with an "interest-only mortgage!" You'll get a low mortgage payment, and you'll maximize your tax deduction, all on your current income! Sounds good, right?
Sure, but there's considerably more you need to know before you get an interest-only mortgage.
For starters, the name is misleading. There is no such thing as an interest-only mortgage, because eventually you'll have to pay the loan principal as well. What you're really getting is an interest-only payment method which can be combined with any type of traditional mortgage.
The other thing you'll want to keep in mind is that the benefits are way overblown. In the early years of a standard mortgage, the interest takes up about 95 cents of each dollar paid to the lender. The standard payment on a 6%, $100,000 loan is about $600; of that, $500 is interest, "saving" you just $100 per month. Moreover, not paying any principal now means that you'll pay more interest later. We'll say some more about the real cost of interest-only payments later in this article.
Interest-only payment mortgages aren't a new offering. Rather, like many innovative methods, they originally grew out of the less-rigid and more inventive jumbo mortgage markets. (Mortgages for amounts larger than Fannie Mae and Freddie Mac can purchase are called jumbos. More on that here.)
As such, they were typically aimed at well-heeled, savvy-investor-type clients who preferred to utilize what would have been the principal portion of their payment for other, hopefully more productive investments.
Because they were mostly jumbo loans, obviously the difference in monthly payment grows with the larger loan amount. The $100 per month difference in the $100,000 example above grows to $1,000 per month on a $1,000,000 loan, which is a substantial amount of cash that could be put to better use. For example, while real estate might produce a "return" of the inflation rate plus a couple of percentage points, putting that money to work in the stock market instead could offer much higher returns. A savvy investor might just be able to grow his investment very handsomely in a short period -- leveraging their incomes to build asset strength.
This is a viable use of interest-only payments, but naturally there are risks, especially in stocks. However, the type of savvy-investor-type people we're talking about here normally has assets sufficient to help offset any risks of not paying off their homes should they need to sell or refinance. Their risk is less than yours or mine would be.
Most interest-only payment schedules are offered on Adjustable Rate Mortgages (ARMs), but they can be found on a fixed rate mortgage (FRM) as well. They've also entered the mainstream, so that they're available to just about all borrowers. The loans you'll find will most likely be sold to a secondary market dealer, so let's look at Fannie Mae's program.
Way back in 2001, Fannie Mae began purchasing from lenders an interesting version of a FRM featuring interest-only payments. Called "InterestFirst", it features back-to-back 15-year terms, with the first period comprised of interest-only payments and the second fully-amortizing. Fannie dropped the moniker in 2007 but allowed for an expanded menu of payment "features" to be added to a wider range of products at that time. Borrowers who selected this unique offering often paid a little extra for this product, as the rate for the InterestFirst product was slightly above the rate for a similar, but fully-amortizing, product.
Interest-only payment periods almost never run for the entire term of the loan, even when a fixed-rate mortgage is the underlying instrument. Even the Fannie InterestFirst product only allowed for interest-only payments for one-half of the total term.
Interest-only payments more typically expire at the end of a set period, making them a frequent companion to "hybrid" ARMs. (To learn more about how ARMs work, click here.) Once the interest-only period ends, your payment will rise to include both principal and interest.
Then and Now
Where interest-only payment methods were formerly used for income leverage purposes -- using the same income stream to buy a home while accumulating other assets -- today's loans aren't being pitched only to well-to-do, sophisticated investors. While "cash- flow" purposes are still common, another audience with a different need has developed.
In the past several years, low mortgage rates, affordable housing initiatives, and innovative financing options have served to drive perhaps millions of potential homebuyers into the marketplace. That new demand has, in many areas, outstripped the supply of desirable homes, leading to what is termed a "seller's market," in which a lot of potential buyers compete for desirable properties. That demand, in turn, has allowed sellers to ask more for their homes -- and get it. Buyers without significant income or asset strength may have found themselves outbid and out of the running for a desirable property. Affordability, helped by falling interest rates, was now compromised by rising prices.
Interest-only payment options began to be offered to the masses not as a way to leverage their money, but rather as a way to borrow more money while not increasing the monthly payment. In the example above, the monthly payment of $600; about $500 of that is interest, and only about $100 goes toward repaying the principal. With an interest-only arrangement, all of the $600 pays the interest cost.
That extra $100 in monthly flexibility would allow you to borrow an additional $20,000 -- enough to be the high bidder, or to help buy a somewhat larger home. Borrowers employing this method aren't "cash-flow" or "income-leveraging" borrowers. What they're doing is buying more debt. Call them "debt leveragers."
Leveraging and Risk
Of course, sophisticated investors understand that with increased leverage comes increased risk. In this case, borrowers who "debt leverage" themselves into a more expensive home, with a larger mortgage, gamble not only that their income will rise in the years ahead, but that the home will appreciate, as well. Since they're not reducing the principal balance, they're not building any equity in their home. Instead, they're counting on the market to do that for them. That's not so much of a gamble when homes are appreciating, but it could spell big trouble in a down real estate market.
At the same time, they're betting that when -- not if -- those higher payments come due, they will have increased their income enough to cover those increases. And those increases can be substantial.
"Term Compression" and "Payment Shock" Risks
Most of our examples so far have dealt with interest-only payments overlaid on a fixed-rate mortgage. For ease of explanation, so will this one. However, we'll limit the interest-only payment period to five years, after which a fully-amortizing payment will be required.
In a fully-amortizing mortgage, your payments are based on the full term, typically 30 years. The $600 example above is based on a full 30-year term, with the "debt leveraged" borrowers spending all of that $600 on interest costs alone ($120,000 loan amount). After five years, the interest-only period expires and the borrower still owes $120,000 at 6%. However, that borrower no longer has 30 years over which to repay the outstanding balance; he has only 25 years. And since the payment is calculated on that shorter repayment term, the guaranteed result is a higher monthly payment: it jumps from $600 (interest-only) to $773 (now fully amortizing). That $173 jump represents a 29% increase in the monthly payment, so our borrowers are essentially betting that their income will have increased by at least that much. (By comparison, a fully-amortizing $120,000 loan at 6% would have had a fixed monthly payment of $719).
In our example, over the first five years, our borrowers would have spent $34,833 in interest. Over the remaining 25 years, total interest charges would be an additional $111,949 for a total of $146,782 in interest cost. If the borrowers had taken a fully- amortizing 30-year fixed-rate mortgage with the same specifications, their total interest cost would have been $139,006. In short, that interest-only payment scheme cost nearly an additional $8,000 over the life of the loan.
Most people don't usually remain in their mortgages for a full 30 years, so such an argument doesn't apply to everyone. here. However, a fully-amortizing loan as above, after five years, has a remaining balance of $8,300 less than the interest-only one does.
Market Risk I
Not repaying principal, and therefore not building any equity through debt retirement, means that an interest-only borrower is counting on market appreciation (price inflation) to help her own more of her home. Of course, this requires that prices increase while she holds the mortgage. Now, folks who follow the national realty markets are quick to point out, prior to the Great Recession that there hasn't been a broad decline in home prices since the Great Depression. However, you don't own the national realty market; you own a single home in a single neighborhood in a single town, and those followers will also concede that prices can and do increase and decrease regularly on a localized basis.
So what does this mean to the interest-only borrower? There is a danger in not reducing the balance. If prices should fail to increase during the interest-only period, and if the borrower should find a need to sell the home, he could potentially be on the hook for thousands of dollars in sales costs which would need to be paid out of whatever equity (in the form of the down payment) he started out with. According to the National Association of Realtors, typical down payments have fallen from 10% in 1990 to about 3% in 1999, so it's likely that at least some borrowers could be courting trouble here. Of course, times have changed again, and the average down payment was back up 11% in 2016; still, not building any equity through retirement of principal would mean that more than half this amount would be eaten up if the home needed to be sold.
Market Risk II
The more extreme side of Market Risk I, of course, is that prices actually decline during the mortgage holding period. If our borrowers finds themselves in that situation, coupled with a low downpayment, they could easily find themselves "underwater" -- a descriptive term that means they'll sell the property for less than the remaining balance of the mortgage. In that unhappy case, the borrowers cannot sell without somehow coming up with what would likely be several thousand dollars to satisfy the mortgage balance as well as any sales charges (commissions, inspections, etc).
We noted before that payments made in the early years of a fully- amortizing are largely comprised of interest. However, in the examples above, we noted that a fully-amortizing loan was paid down by about $8,000 after five years. That's enough to cover the sales charges for a $130,000 home.
Interest Rate Risk
All the examples so far have been based on mortgages with a fixed interest rate. Unfortunately, most of the interest-only loans being made today feature only short fixed interest periods, if any; some featuring adjustable rates which can change each month. As this is written, low interest rates are the order of the day, with some short-term rates at or near historic lows -- but if history teaches us nothing else, it's that low rates inevitably rise.
Above, we discussed term compression and its effect on payments, which causes them to rise above what they otherwise would be when the interest-only period ends. Now, magnify that compressed repayment term with a jump in interest rates, and you've got a recipe for a fiscal catastrophe.
Figure this: you, the interest-only borrower, have been happily making payments at $600 for the first five years of your (for now) fixed-rate loan. All the while, interest rates have been rising from their near-40 year lows to what could be considered "normal" -- about 7% -- and your monthly payment climbs over 40% to $848 per month. If you should find yourself in a period of considerably higher interest rates when the fixed-rate and interest-only period ends, your rate could climb to 9% or more -- in which case your monthly payment could jump to $1,000 per month, or more.
Also at the moment, liberal and flexible mortgage underwriting standards are allowing borrowers to borrow more money for the same income, because qualifying ratios have been greatly expanded. Theoretically, a borrower's budget might already be pretty stretched to the limit -- and that's before a nasty rate and payment hike.
The Good News
Interest-only payments do have a place in the world. In our opinion, at least, there are practical uses for borrowers to utilize a mortgage with interest-only payments -- but none of them involve leveraging themselves into a larger mortgage, particularly one with a variable interest rate.
If a borrower could afford either fully-amortizing or interest-only payments, under what circumstances might choosing the interest-only option provide a benefit?
If the interest-only payments are overlaid on a fixed-rate mortgage product with a fixed period of five years, a prudent borrower could invest the payment differential in a cash investment -- like a CD -- at an interest rate of perhaps 2% for the period. Over the five year fixed-rate period, that regular stream of deposits would grow to a balance of $7,566. At the beginning of the sixth year, should the mortgage rate increase to 7% (and with a payment term compression to 25 years, as described previously), the $173 additional due each month could be drawn from this "subsidy account." That way, the borrower would have no budget issues for a period of 44 months.
Of course, that's assuming just a 2% return over the period. If a borrower could locate a higher return over that period, that "subsidy" could last longer. However, it's very likely that after the sixth year, the mortgage rate would again change -- and a higher rate for the next year would certainly shorten the "subsidy" period.
Investing in the asset itself
Another worthwhile use for the "spare" cash that an interest-only loan provides would be to spruce up the home itself. The $100 per month (from our example) would allow the homeowner to invest up to $1,200 per year in improvement projects which can increase the value of the home. This may not buy a brand-new kitchen, but might be enough for a minor kitchen remodel, a new roof, bathroom upgrade, new energy-efficient windows, or vinyl siding, to name a few. (A pool sounds nice, but almost never pays for itself in an improved sales price.) Improving the value of the asset may mean a higher selling price later as well as some enjoyment now.
Money for college...
Financial planners and investment advisors will tell you that perhaps the most important component of an investment is the length of time over which it has to compound. This can be especially true if you have a young child you wish to send to college; the earlier that you can commit money to an investment plan, the more likely you will be able to reach or be closer to your goals. After the interest-only period ends, of course, you might not have additional money to commit to the savings plan, but the money already committed will have a longer compounding period.
...Money for retirement, too
Are you an older homeowner, and seeing retirement on the horizon? Have your children grown and moved away, leaving you with a big home and no one to fill it... and you think you might sell it in just a few years? An interest-only payment scheme might work for you here, too. If you've been in your home for a while, your loan balance has shrunk; refinancing to a new mortgage, with a fresh 30-year term and interest-only payments, could free up a considerable amount of money each month to maximize your IRA contributions or other investments.
The Seasonal Income Factor
Not everyone in the workforce brings home a regular paycheck. Those with seasonal income, or who get a sizable portion of their income from bonuses or other sporadic payments, might also benefit from the lower payments that an interest-only scheme can provide. This can allow the borrower to make a smaller payment when cash is tight, then accelerate payments -- including principal -- when money is available. In this way, the borrower could end up with the best of both worlds.
As A Prepayment Vehicle (accelerated amortization) New section!
Some lenders are pitching short-term interest-only ARMs as a means of paying down your outstanding loan amount. Under this scenario, you send in more than just the principal required to fully-amortize the loan -- a sizable amount more. Typically, this is offered to borrowers who can qualify for the payments on a fixed rate loan, but are instead encouraged to take a short- term ARM with its low-low rate and to make payments as though it were a fixed rate at a much higher interest rate.
This would seem to defeat the purpose of selecting an interest-only payment plan, but there's nothing wrong with it -- except you don't need interest-only payments to make it happen; the benefit actually comes from switching from a higher fixed-rate, fixed-payment amortization schedule to a lower adjustable-rate, frequently recast amortization schedule.
You should also know that rates for some interest-only product are higher than their fully-amortizing counterparts, so if you're attracted to this idea, you might actually do better basing your prepayment strategy on an otherwise-identical fully-amortizing product.
The process of making a Constant Level Payment isn't novel -- paying as though your loan's interest rate is 6% when only a 4% payment is required, for example -- and may actually work to your advantage, provided interest rates don't rise appreciably (always a gamble). To see how this might work, we've developed a series of companion charts utilizing real values to demonstrate how this can work for -- or against -- your goals.
Still interested in interest-only payments?
With their typically-lower-than-fixed interest rate, and coupled with interest-only payments, an ARM -- especially a short-term ARM -- could represent a way to have the lowest possible monthly payment and still be able to own your own home. However, all that flexibility comes with risks.
Some mortgage products, though, allow you to have your choice of payment plan, including interest-only, fully-amortizing or accelerated-amortizing. These so-called "option" or "pick-a-payment" ARMs are gaining in popularity, as they allow you to determine how best to apply your budget to your mortgage.
If you are already a candidate for an ARM, and if you have college, retirement or investment needs to take care of, you might consider adding interest-only payments to your ARM (or even taking an InterestFirst-style product) in order to more fully fund the other financial needs in your life. Maybe you've got a gambler's instincts, and want to bet that your home will be worth more in the future... or that you can invest the money better elsewhere than paying down your mortgage balance. As far as maximizing your tax deduction, remember that not only is that vast majority of your payment already comprised of interest, but that only a fraction of every dollar in interest you spend is tax deductible, anyway.
Of course, no one except you can say for sure what sort of mortgage options you'll need or want. However, you should be aware of the issues and drawbacks which surround those choices before you respond to marketing pitches.
Click here to view the companion chart series.
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