Housing Counsel: Interest Only Loan Potential for Disaster

Written by Posted On Sunday, 05 March 2006 16:00

Question: I am a first time home buyer with limited income. My mortgage lender has suggested that I should consider obtaining an interest only loan. I have heard that these kind of loans are not necessarily in the best interest of consumers. Can you explain what an interest only loan is, and why it is problematic?

Answer: An interest only loan is exactly what it says: the borrower pays interest only for a period of time.

Let's take this simple example: you borrow $200,000 at 6 percent. If you amortize this over 30 years, your monthly payment would be $1199.11. This only includes principal and interest, and not taxes and insurance. The principle behind an amortization loan is that at the end of 30 years, you will have paid off the loan.

Why? Because each and every month, a portion of your mortgage payment goes to reduce the then outstanding principal balance of your loan. For the first seven years, the outstanding principal balance goes down very slowly. However, if you keep the loan for a longer period of time, eventually more of your payment will go toward reducing the principal and less to paying mortgage interest.

Now let's look at an interest only loan in the same amount and at the same rate. The monthly payment is $1000. No portion of this payment goes to reduce the original principal amount of $200,000.

In our 30 year amortization example, when you make the very first payment, $199.11 will go toward principal, thereby reducing the balance down to $199,800.89. If you take 6 percent of this new balance and divide it by 12, the interest due on the new balance has been reduced down to $999.00. This means that your next mortgage payment will reduce the principal balance by $200.11 ($1199.11 - $999).

Computers obviously can do this math much quicker, so I will only show the example for the first two months payments.

But as you can plainly see, for each and every monthly mortgage payment you make, you are slowly reducing the amount you owe your lender.

Your mortgage broker is correct: in our example, if you take an interest only loan, you will theoretically be saving almost $200 month on the mortgage payment. I purposely use the word "theoretically" because typically, interest rates on these interest only loans will be one -- eight to one-quarter of a percent higher than the standard 30 year first amortized mortgage.

Why? Interest only rates are not new, although they have become very popular in the past year. My research indicates that these types of loans actually originated in the 1920's. However, when our country went into an economic depression in the 1930's, many of the mortgages that were foreclosed upon were interest only loans.

So lenders consider these loans a higher risk and accordingly charge a slightly higher interest rate to compensate for this risk.

There is yet another problem with these types of loans. Typically, an interest-only loan is an adjustable rate mortgage (ARM). That means that for the first five years, you will pay interest only, but thereafter you will start paying a higher rate, and the payments will be established so that you will pay off the loan at the end of a fixed period of time (15 or 30).

This means that when your interest only payments stop, you will have to start making substantially higher monthly payments to "catch up."

Can you afford this? Are you on a fixed income, with limited possibilities of getting a higher salary down the road. And how long do you plan to keep this house?

These are all questions which you must answer before you accept that interest only loan.

In our example, you buy your house for $225,000 and get that $200,000 loan. Five years from now, you will still owe the same amount.

Real estate has appreciated dramatically over the past few years. But there is absolutely no guarantee that this will continue. Real estate values are like a roller-coaster; they have their ups and downs.

I recall many people who purchased homes in the Capital Hill area of the District of Columbia at the peak of the market in late 1989. When they sold their homes in the mid-90s (before the boom started) they actually had to come up with money because their mortgage exceeded the depreciated value of their house.

Consumers should not buy their principal residence with the idea that it will be a good investment. You buy because you want a roof over your head, and a place where you and your family will be comfortable. If the property appreciates in value, that's your good fortune.

When you obtain an interest only loan, however, you can only expect (or hope) that the house will appreciate, because that is the only way that you will create equity in your house. With an amortized loan, on the other hand, you build up equity as your mortgage balance decreases.

Interest only loans can be useful for some consumers:

  • If you know that you will not be living in the house for more than a few years

  • If you know that your income will increase within the next five years so that you will be able to afford the increased mortgage

  • If you are prepared to take a chance and gamble with the future.

As with any major financial decision, you should shop around, ask questions, and consult your legal and financial advisors before signing any legal documents.

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Benny L Kass

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.

kasslegalgroup.com

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