The Principal Facts of InterestOnly Mortgages
The Principal Facts of InterestOnly Mortgages
Step right up! Buy the house of your dreams with an "interestonly 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 interestonly mortgage.
For starters, the name is misleading. There is no such thing as an interestonly mortgage, because eventually you'll have to pay the loan principal as well. What you're really getting is an interestonly 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 interestonly payments later in this article.
Some History
Interestonly payment mortgages aren't a new offering. Rather, like many innovative methods, they originally grew out of the lessrigid 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 wellheeled, savvyinvestortype 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 interestonly payments, but naturally there are risks, especially in stocks. However, the type of savvyinvestortype 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 interestonly 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.
Fannie Mae purchases from lenders an interesting version of a FRM featuring interestonly payments. Called "InterestFirst", it features backtoback 15year terms, with the first period comprised of interestonly payments and the second fullyamortizing. Expect to pay a little extra for this product: the rate for the InterestFirst product is slightly above the rate for a similar, but fullyamortizing, product.
Not Forever
Interestonly payment periods almost never run for the entire term of the loan, even when a fixedrate mortgage is the underlying instrument. Even the InterestFirst product only allows for interestonly payments for onehalf of the total term.
Interestonly 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 interestonly period ends, your payment will rise to include both principal and interest.
Then and Now
Where interestonly 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 welltodo, 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.
"DebtLeveragers"
Interestonly 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 interestonly 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 "cashflow" or "incomeleveraging" 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 Risk
Most of our examples so far have dealt with interestonly payments overlaid on a fixedrate mortgage. For ease of explanation, so will this one. However, we'll limit the interestonly payment period to five years, after which a fullyamortizing payment will be required.
In a fullyamortizing mortgage, your payments are based on the full term, typically 30 years. The $600 example above is based on a full 30year term, with the "debt leveraged" borrowers spending all of that $600 on interest costs alone ($120,000 loan amount). After five years, the interestonly 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 (interestonly) 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 fullyamortizing $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 30year fixedrate mortgage with the same specifications, their total interest cost would have been $139,006. In short, that interestonly 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 fullyamortizing loan as above, after five years, has a remaining balance of $8,300 less than the interestonly one does.
Market Risk I
Not repaying principal, and therefore not building any equity through debt retirement, means that an interestonly 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 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 interestonly borrower? There is a danger in not reducing the balance. If prices should fail to increase during the interestonly 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.
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 fullyamortizing 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 interestonly 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 shortterm 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 interestonly 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 interestonly borrower, have been happily making payments at $600 for the first five years of your (for now) fixedrate loan. All the while, interest rates have been rising from their near40 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 fixedrate and interestonly 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
Interestonly payments do have a place in the world. In our opinion, at least, there are practical uses for borrowers to utilize a mortgage with interestonly 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 fullyamortizing or interestonly payments, under what circumstances might choosing the interestonly option provide a benefit?
Accumulating assets
If the interestonly payments are overlaid on a fixedrate 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 fixedrate 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 interestonly 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 brandnew kitchen, but might be enough for a minor kitchen remodel, a new roof, bathroom upgrade, new energyefficient 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 interestonly 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 interestonly 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 30year term and interestonly 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 interestonly 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 shortterm interestonly ARMs as a means of paying down your outstanding loan amount. Under this scenario, you send in more than just the principle required to fullyamortize 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 lowlow 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 interestonly payment plan, but there's nothing wrong with it  except you don't need interestonly payments to make it happen; the benefit actually comes from switching from a higher fixedrate, fixedpayment amortization schedule to a lower adjustablerate, frequently recast amortization schedule.
You should also know that rates for some interestonly product are higher than their fullyamortizing counterparts, so if you're attracted to this idea, you might actually do better basing your prepayment strategy on an otherwiseidentical fullyamortizing 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 valuesto demonstrate how this can work for  or against  your goals.
Still interested in interestonly payments?
With their typicallylowerthanfixed interest rate, and coupled with interestonly payments, an ARM  especially a shortterm 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 interestonly, fullyamortizing or acceleratedamortizing. These socalled "option" or "pickapayment" 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 interestonly payments to your ARM (or even taking an InterestFirststyle 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.
Copyright 2005, HSH® Associates. All rights reserved.
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