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The hyperactive Washington housing market — which continues to see annual appreciation rates around 10 percent — has pushed more and more home shoppers to consider interest-only loans. From relative obscurity, this type of adjustable-rate mortgage, or ARM, has become the loan of choice for many borrowers looking to lower their monthly bill or to afford that perfect — but somewhat out of their price range — home.
Unfortunately, many of these buyers don’t realize the risks involved with an interest-only mortgage. But before talking about the pros and cons of interest-only mortgages, let’s take a look at just what they are and how they work.
As you might have suspected, with an interest-only loan, your mortgage payment consists only of interest on your loan. No part of the payment goes toward paying off the loan’s principle.
That trims initial monthly payments dramatically. Consider that same $200,000 fixed-rate loan, which costs $1,230 a month over 30 years. An adjustable-rate interest-only loan at 3.38 percent cuts that payment by more than half, to just $563 a month.
Sounds great. But it comes at a cost.
First off, you’re not paying off your mortgage. Let’s face it, Americans aren’t the world’s greatest savers. Delayed gratification simply isn’t our forte. Indeed, almost unbelievably, Americans have at times in our history spent more than we earned. That’s a negative savings rate. Japan, we are not. A traditional mortgage acts as a forced savings mechanism, helping you to build wealth. Given our tendencies, we can use any help we can get to improve our savings rate.
Another ARM problem is that after five or seven years, depending the loan contract, you either refinance, pay the balance in a lump sum, or start paying off the principal, in which case the payments jump skyward.
Now, over the past few years, this wasn’t a problem. Rising housing prices and falling interest rates gave the borrower some pretty good options. You could simply sell the house, take the profit and use that as a hefty down payment on a similar house, which would keep the new mortgage low and thus keep monthly payments in check.
You also could refinance at a low interest rate, which would keep the payment down.
But that was then, this is now. Given the spectacular rise in housing prices over the past decade, many analysts suspect a housing bubble may exist. Even if they’re wrong, it’s not out of the question that we might have several years of flat or slightly lower housing prices in the area.
If that’s not scary enough, interest rates are almost sure to rise over the next five years. Let’s see what this new reality does to our interest-only borrower, whom we’ll call Joe.
Having looked high and low, Joe finds the perfect house for him and his partner, John. There’s only one problem: he can’t afford the $2,000 a month payment using a 30-year fixed. Joe opts for the $1,200 a month payment with an interest-only loan, a payment he can barely afford.
For the next five years, Joe and John enjoy their new home. Barbecues with the neighbors, mowing the lawn and yelling at those damn kids to get off the lawn. Unfortunately, a tough housing market has caused the price of his house to fall $25,000. In addition, interest rates have risen 2 percentage points.
One day, Joe gets a call from the bank. “Joe, we have to talk,: says the bank. “Your five years are up.”
The bank gives Joe three choices. For the first option, he can refinance the loan, but because interest rates have risen, his payment will go up to $1,500. “I can’t afford that,” Joe says.
Okay, the bank says. How about selling the house and paying off the loan? “My house is worth $25,000 less now than before, and I don’t have the money to pay off the difference,” Joe says.
Well, says the bank, here’s you last option. You can begin paying off the loan and your interest rate will go up, giving you a payment of $1,800 a month. “No way, that’s worse than the first deal,” says Joe.
As you can see, an interest-only loan can lead to some serious pain if housing prices fall or interest rates rise. As a result, most financial planners — myself included — recommend that house hunters shouldn’t use interest-only loans to buy homes that they can’t afford using traditional mortgages.
Now, that’s not to say that interest-only loans don’t work for anyone. In my opinion, an interest-only mortgage might be a good fit for someone who expects to earn a lot more in a few years, like a law student.
It also would work for someone who makes enough money to afford the payment using a 30-year fixed mortgage but wants to take the money saved by using an interest-only loan to buy investments that he is confident will make money.
But for what I’ve seen, these aren’t the people clamoring for interest-only loans. It’s the 30-year-old who wants a condo in Georgetown when he should be looking Fairfax or Rockville.
An interest-only loan might get him the dream house, but it’s a big gamble that may not pay off.
Mark Helm is a personal finance writer and financial planner. He can be reached at HelmFinancial@aol.com.