Interest gains on interest-only
As home prices zoom upward, some home buyers
are turning to interest-only home loans.
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 recently, as interest rates
have risen from 46-year lows 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 refinancing boom that ended in 2003, 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,"
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
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
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.