Interest Only Loans Part I - The First-Time Home Buyer - 10/14/2004 - Mortgage Loan Refinance Debt Equity

Interest Only Loans Part I: The First-Time Home Buyer
by Henry Savage

Check out the difference: The principal and interest (P&I) payment on a $300,000 loan amortized over 30 years at six percent is $1,799 per month. If you were to pay only the interest on the same loan, the payment would drop to $1,500.

Interest-only loans are widely available these days because lenders react to market demand. The plain fact is that i/o loans have grown considerably in popularity. If you examine what has transpired in the housing market over the last few years, it's no wonder i/o loans are a big hit. Consider the following:

 

• The upward spiral on home prices has made housing less affordable. An i/o loan allows a buyer to afford a bigger loan to buy a more expensive house.

   

• The rock-bottom interest rate environment encourages an interest-only mentality. People are thinking, "Why should I bother paying off a loan with such a low interest rate? I can put my money in a better place."

   

• Existing homeowners enjoying fabulous appreciation are refinancing their amortized loan in to an i/o loan. Their thinking is this: "Why should I bother chipping away at my loan balance when my house continues to skyrocket in value."

Let's examine the first bullet.

It's no secret that home prices have increased to lofty levels. While existing homeowners are celebrating their new-found wealth, first-time homebuyers are getting stung by sticker shock. I see it all the time. A client phones me up to get pre-approved for a new mortgage. I run the numbers, pull the credit and issue a pre-approval letter for a certain loan amount. The client then drives around with his real estate agent only to find out that the homes he is qualified to buy are far inferior to his expectations.

The client comes back to me with his head filled with disappointment. Enter the world of interest-only loans. Here's a rule of thumb: switching to an i/o loan will increase affordability by 20 percent. In other words, a buyer can increase his purchase price range by 20 percent without increasing the monthly payment.

Twenty percent translates to a much more expensive house. If you were originally pre-approved for a loan amount of $250,000, you can now bump it up to $300,000. $300,000 gets bumped to $360,000. $400,000 gets bumped to $480,000.

Suddenly, my client can afford the house he wants. But it's very important to know the downside. Making loan payments that don't curtail principal increases the chance of being "upside down" on your mortgage. What if, heaven forbid, you buy a house with a tiny down payment and the market turns south? Your house value could drop to a level below the balance of the mortgage. This is a bleak scenario if for some reason you had to put your house on the market.

Another thing to consider is that most lenders only offer i/o options on adjustable-rate mortgages. If you are risk averse and hoping for a fixed rate, consider a 10/1 ARM with an i/o payment option. The rate is fixed for the first 10 years -- long enough for most folks to be comfortable.

Other ARMs allowing i/o payments are also available -- make sure you understand them fully before signing up. A 3/1 ARM, for example will carry a very low rate. The low rate, coupled with the i/o payment, will greatly increase your borrowing power. But understand that not only can your rate increase in a mere three years, but your i/o feature may be limited to three years. This would bring the possibility of a principal and interest payment based on the remaining 27-year term at a higher rate. Translation: payment shock.

I certainly understand the dilemma facing first-time homebuyers. If you plan on taking out an i/o loan in order to qualify for more house, make sure you either have a good down payment or plan on holding the property for a reasonable period of time. Real estate has proven to appreciate nicely over time, but you don't want to be stuck in a position of having to sell during a dip in the cycle. Also, remember that an i/o loan does not prohibit you from making payments to the principal balance. If you can afford to make principal payments and you have no where better to put the money, go ahead and chip away at the balance.

That's the subject of the next column: To Pay or Not Pay Down the Mortgage Balance. Stay tuned.