Hawaii Mortgage Shop Explains Interest-Only Mortgages

More home for less money?

The answer may lie in an interest-only mortgage loan, an old product that is making a big comeback as lenders devise ways to turn rising home prices to their advantage. The mechanics of an interest-only mortgage loan are simple. For a set period (generally in the early years of a mortgage when most of the payment goes toward interest anyway), you pay only the interest portion of your monthly payment, freeing up for other purposes the amount that would normally go toward paying off the principal. At the end of the interest-only period, your loan reverts back to its original terms, with the monthly payments adjusted upward to reflect full amortization over the remaining years of the loan (for instance, following a five-year interest-only loan, a 30-year mortgage would now fully amortize over 25 years).

You won't build equity during the interest-only term, but it could help you close on the home you want instead of settling for the home you can afford. Since you'll be qualified based on the interest-only payment and will likely refinance before the interest-only term expires anyway, it could be a way to effectively lease your dream home now and invest the principal portion of your payment elsewhere while realizing the tax advantages and appreciation that accompany homeownership. The concept is not a new one; back in the Roaring Twenties, interest-only mortgages were commonplace. At the end of the term, homeowners typically refinanced. The system worked great unless your home lost value or you lost your job. Which is exactly what happened when the Great Depression hit. Foreclosures skyrocketed and lenders abruptly stopped writing interest-only loans. (The practice has continued elsewhere, however, notably in Great Britain.) Wells Fargo began offering interest-only products, primarily to its jumbo loan c stomers, in June 2001. Washington Mutual followed with interest-only loans last September. Fannie Mae purchased $1.2 billion interest-only loans on the secondary market last year; it's not a sizable market segment yet, but it's one that is expected to grow.

Growing interest in interest-only

It may be logical to assume that the recent economic downturn in some way prompted the sudden reappearance of interest-only loans as a way to help struggling home buyers purchase or hold onto their homes during the lean years. In fact, just the opposite was the case, according to Brad Blackwell, national sales manager for Wells Fargo Home Mortgage. "Actually, it's almost the converse of that. Many borrowers want to take their additional cash flow and invest it one way or another," he says. "The economy played no factor in our decision; we had actually been developing it since the economy was booming." Investor sophistication, sky's-the-limit housing prices and the consumer appetite for immediate gratification have all combined to make interest-only loans viable again. Blackwell says the product is particularly strong in Wells Fargo's home state of California. "California is the place where this is most popular because, unfortunately, in California, a $625,000 or even a $720,000 home is a simple tract home on a small lot," he says. Other active markets include New York City, Chicago and Washington, D.C. Interest-only loans are the latest tool aimed at offsetting high home prices. Since the '60s, lenders have stretched mortgages from 20 years to 25 years to the current 30-year term to buoy the home-buying market.

They are holding onto their mortgages for shorter and shorter periods. People are refinancing everywhere from 1 year to 7 years, whether for relocation purposes or because they simply wish to refinance," he says. "I think it's safe to say that borrowers are not nearly as interested in owning their home outright as they are in acquiring a quality piece of property that will build equity for them in the future through appreciation." That's a major selling point for the interest-only loan, especially in high-ticket housing markets. On a 30-year amortizing loan of $500,000 at 6.5 percent fixed, the initial monthly payment would be $3,160, with $2,708 going to interest and $452 toward principal. With an interest-only loan, the fixed monthly payment would be $2,708. "I might not normally feel comfortable buying a home with a $500,000 mortgage, but by reducing my payments $452 per month, it now becomes a viable option for me to get the house that suits my lifestyle," Blackwell says. Other home buyers simply want to make use of the principal portion of the payment for other investments and are willing to forego the equity proposition to do so. "One of the things that borrowers have told us they use it for is funding their retirement plans. Most people don't fully fund their 401(k), for example. Well, that $452 extra a month, that's an extra $5,400 that can be channeled into a 401(k), giving them more tax advantages there while retaining the tax deductibility of a $500,000 mortgage." Tax advantages to interest-only vs. amortizing mortgages are admittedly minimal because you're not paying your principal down each month, your interest-only portion remains fixed instead of declining, however infinitesimally, over time. Blackwell says an interest-only loan represents less risk to a lender because it gives the homeowner more cash-management options; the payments are lower by definition; and the principal "nut" can be used to stave off more pressing debt that might eventually threaten the mortgage, such as high-interest credit card bills. The homeowner can also choose to make principal payments at any time.

Easy Money

On the surface, the interest-only mortgage resembles nothing so much as the current no-interest, easy-lease terms of the automobile industry, where buyers typically are more concerned with having than owning. Ruth Hayden, financial educator and author of For Richer Not Poorer: The Money Book for Couples, says the similarity is more than skin deep. "This is what I call Yuppie money; this is appealing to Yuppie money folks. Yuppie money is, 'How far can we leverage out? How far can we cash flow? How much stuff can we have? You know, we can get a much bigger car with a lease, we can get a much bigger house if we're not paying off principal, we can have much nicer furniture, we can take much nicer trips.' It's all about the stuff." Hayden has seen firsthand the downside of Yuppie money: "When we hit the bear market after the bull market, a lot of my Yuppie-moneyed people collapsed. They had maxed out on margin loans, house equity, credit cards and lines of credit, and now for the first time had to look at their lifestyles." The danger in interest-only mortgages, she warns, lies in the expectations of the home buyers. "People would have to go into this looking at it as interest-deductible rent and not assuming they're going to get any money out, or if they do, it's a bonus. If they have no interest in building up equity in a house, then it can work for them," she says. "The real estate market goes through waves just like the stock market does. If you have to sell during that period of time, you're in trouble." She doesn't consider interest-only mortgages viable in the long run. "It doesn't build net worth at all. When you're in your 80s, are you still going to be leveraging or do you want to own your home?"