We have an interest only
loan and everything we
have seen lately says
that they are a bad loan to have.
Did we make the right decision
to get the interest only?
Oscar V. – Oakland, CA
I too have noticed a lot
in what I have read
(front page
of the SF Chronicle May 20,
2005) lately that interest only
loans are the “smoking gun” or
the red headed stepchild in
the housing market. They are
getting a really bad rap. The
reason why is simple.
People are using them wrong.
You wouldn’t use a rubber mallet
to chop down a tree so why
would you use a short–term
loan for a long-term investment?
The answer is because it’s
easy to be persuaded by the
attractive interest rates and
payments. Remember, a bad
carpenter blames his tools.
If you have the wrong tool
for the job the job won’t be
done right. Interest only
loans serve a function and
just like with everything in
life there is a good
side and a bad side.
Economists say that the
higher use of interest only
loans means there is
more speculation in the
housing market and we are
at the top of the cycle. Other experts say that interest only
loans are a great tool and
when educated, people
can use them intelligently to
afford higher priced homes.
I am inclined to believe the
experts. The national
average median home price
is $204,000. The median
home price in the Bay Area
is around $640,000. Don’t
you think if we have to carry
debt 3 times larger than that
of the nation average we
may want to manage the
debt a little differently
and maybe use some “smarter”
loans and payment options?
First of all let me correct one
thing. Interest only’s are not
loans. They are payment
options attached to certain
loans. You can have a loan
that is interest only for it’s
whole term and then have a
balloon payment due at the
end. That is sold school and
that is known as a simple
interest loan. Like if a seller
carries back a note or you get a
“hard money” or private money
loan. THAT is an interest only
loan. The ones being referred to
today are short-term fixed
rate loans (1, 3, 5, 7 & 10 year
fixed rate terms on loans that
last for 30 years) that have an
interest only payment option
that is typically for as long
as the fixed period. For example,
if you have a 5-year fixed
(A loan for 30 years with an
interest rate fixed for 5 years)
with an interest only payment
option you only have to pay
back the interest for the first
five years. After that you have
to pay the principal balance
off over the next 25 years
at an adjustable rate.
The benefit is you are
obligating yourself to the
minimum payment of just
interest for the first 5 years.
So if you have a 5-year fixed
for $300,000 at 5%, that gives
you a regular principal and
interest payment of $1,610
a month but with interest
only payment option you
are only obligated to pay
$1,250 a month for the first
5 years. After 5 years your
principal has to be paid back
and the payment increases to $1,753 a month and is then becomes adjustable.
This is where the bad rap
comes in. And yes some
people are doing it wrong.
They get a really short-term
loan, 1 to 3 years fixed, for
a home they plan on being
in for a longer period of time.
They do this because of
the extremely low interest rate
offered for this time frame.
People are payment driven.
The problem here is they
have the wrong fixed rate term
NOT the interest only payment
option.
Think about this. The average
length of ownership for one home
is around 9 years. The average
length of an economic cycle
is around 7 years. At no time in
the history of America has 10
years elapsed with out an increase
in the value of homes from
that day back 10 years. See where
I’m headed? You should focus on
the term of the fixed rate not
scrutinize the payment option.
So let’s be realistic. Very few
people will be in their house
for 15 years much less 30. So
the financing should reflect
both risk tolerance and
length of ownership. Considering
a loan with a fixed rate term less
than 7 years entails a short-term
benefit, the lower rate & payment
and long-term risk, the longer
adjustable period and higher
total monthly payments. This
should only be considered
if the length of ownership will
be less than 7 years. Period.
If you plan on being in your
home more than 7 years the
10-year is by far the best option.
I hear they are coming out
with a 15-year fixed interest
only period on a 30-year loan.
That is much more conservative
and gives you much
more control over your budget.
OK. So you say in 10 years you
still owe the same amount. Sure.
If you make just the interest only
payment. But remember it is an
option not a mandatory payment.
Most people pay a little more to
pay their loan balance down.
The beauty of interest only is
the payment reflects the balance.
So if you have a $300,000 loan
and you reduce your principal
balance by $500 your next
months payment will be based
$299,500 and will be less than
last month’s. If you make the same
extra payment every month
systematically you will pay off
more & more principal. That is
called “payment responsiveness”
and it sure sounds like
amortization to me! Except in
this case you get to choose
how much or how little you put towards
the payment. Remember with standard
loans all of the interest is paid in the
early years, a majority of your equity
is returned in years 26 through 30,
your payment never goes down and
your are at the maximum interest
rate and payment. With the interest
only payment option you can also
be creative and include bi-weekly
payments if you choose and
guarantee your debt reduction for the
length of the fixed rate term & interest
only period. This in turn allows for a
hedge against mortgage rate increases.
If in 10 years you owe $60,000 less or
have a $240,000 balance, mortgage rates
can go up by almost 2% and if you
refinance into another 10-year you will
have close to the same monthly
payment for another 10 years because
you owe less. That is 20 years in one
house with one refinance. Doesn’t
sound all that risky to me.
Some people pay nothing towards
the principal and that is fine too. As
long as you take the monthly savings
over the regular payment
($1,610 - $1,250 = $360 per month in
the above example) and save it and
invest it. Doesn’t have to be risky.
Even a money market or CD will
provide a greater return than paying
down your loan balance. Basically
you keep what you would have paid
your loan down by and you don’t
have to sell or refinance the house,
which are both expensive, to get
that money back out again. The
interest only payment option gives
you the ability to be in control of
your own funds and your own budget.
The money you save and invest
could be the difference between
having enough savings for retirement
or being house rich and cash poor,
forcing you to refinance, sell or worse
yet take out a reverse mortgage to
get back out the money you worked
so hard to put into the house.
As far as I am concerned the interest
only payment option on short-term
fixed rate mortgages is a beautiful
creation and if used properly can
be the difference between success
and failure in the housing market.
You can e-mail your question to Aaron at: askthemortgageexpert@yahoo.com