As mortgage rates rise and home prices
zoom upward, some home buyers are turning to interest-only home
An interest-only loan allows you to pay just
the interest on the mortgage for a set period, often the first
five, 10 or 15 years. You don't have to pay principal during
that time. When the interest-only phase is up, the monthly payments
skyrocket as you begin paying principal over the remaining term
of the loan. Most borrowers expect to sell the house or refinance
the loan before the interest-only period ends.
The main attraction of an interest-only mortgage
is the lower monthly payment.
"It is becoming something that borrowers
and Realtors are asking for, because it allows the borrower
to afford more house," says Vijay Lala, senior vice president
of product development for Countrywide Home Loans.
This is especially true in the last couple of
months, as interest rates have risen steeply and home prices
have gone nowhere but up. Some home shoppers have found to their
chagrin that the houses they could afford in June are no longer
affordable because of higher rates. Or rather, they found that
their dream houses are no longer affordable with regular, fully
amortizing loans. Enter interest-only mortgages, which increased
in popularity after rates began rising at the end of June.
There had been steady demand for the loan type
during the three-year refinancing boom that just ended, especially
in places with pricey homes on the coasts. They also have been
fashionable in parts of the South.
Two types of borrowers
Who gets the loans?
"It's really borrowers looking to either
leverage their cash and borrowers who want the lowest payments
they can get," Lala says.
For that second group, interest-only mortgages
are the home equivalent to auto leasing, sort of. Both are handy
ways to get something that you otherwise couldn't afford --
a bungalow in Malibu Beach, a BMW Z4.
The first group that Lala mentions consists
largely of wealthier people with complex financial lives. They
use interest-only home loans to free the cash that otherwise
would go toward principal, and invest that cash where it presumably
can bring a better return.
They have the option of paying more than the
minimum amount every month and applying that money toward principal.
If they don't pay extra, they don't contribute toward their
home's equity. They still build equity, though, if the value
increases and they eventually sell the house for more than they
paid for it.
Have a plan
Lenders offer all sorts of interest-only programs.
If you are determined to get one, it might be
best to go through a mortgage broker, who can search for the
appropriate loan offering among various lenders. Countrywide
offers interest-only periods of 10 or 15 years with fixed-rate
and adjustable-rate loans. Another interest-only player, Wells
Fargo, limits its interest-only offerings to adjustable-rate
mortgages. They have five-year interest-only periods.
Joe Rogers, a national sales manager for Wells
Fargo Home Mortgage, says interest-only loans are fine financial
tools. But like all tools, they work best when they are used
for their intended purpose. That means they should be part of
a well-thought-out financial plan.
The best candidate for an interest-only loan is someone who
could afford to pay for the home with a fixed-rate, 30-year
mortgage, but who chooses an interest-only loan for sound reasons
as part of a financial plan, Rogers says. Such a borrower isn't
getting an interest-only loan just to squeeze into a house that
is otherwise unaffordable.
If a borrower doesn't sell the home or refinance
the loan before the interest-only period ends, the monthly minimum
payment rises abruptly. Let's say someone borrows $200,000 at
a fixed rate of 6.5 percent, paying only interest in the first
five years. During those five years, the payments would be $1,083
a month, plus taxes and insurance, with nothing contributed
toward the home's equity. At the beginning of the sixth year,
the monthly payment -- principal and interest -- would rise
to $1,350 in order to pay off the loan over the next 25 years.
By comparison, someone borrowing the same amount
at the same rate, but paying principal and interest the entire
time, would have monthly payments of $1,264. After five years,
the borrower would have accumulated almost $13,000 of equity.
If you get an interest-only loan, you always
have the option of making more than the minimum payment and
having it applied toward principal. This feature appeals to
people who make a good living, but don't have a steady income
from month to month: small-business owners, salespeople who
work on commission, employees whose end-of-year bonuses make
up much of their annual incomes.