This article is the first in a series of informational articles dealing with various aspects of the mortage industry, dubbed 'Mortgage 101'. Throughout the series we’ll examine various types of loans available to home seekers, as well as cover other pertinent mortgage related concepts. As we all know in real estate, an informed agent is an valuable asset to their client.
This week we’ll be discussing the merits and more dubious pitfalls of the 'Interest Only' loan.
'Principal Deferred' Loans
The 'Principal Deferred' Loan – commonly called the 'Interest Only' Loan – isn’t new, but it is the single fastest growing segment of the mortgage industry today, and it’s not hard to understand why: interest rates remain low while home prices continue to climb.
In essence, these loans allow potential homebuyers to defer principal payments for a certain time period. Borrowers can select a two, three, five, seven, or ten-year adjusted rate mortgage (ARM), with a five or 10-year 'Principal Deferred' option to maximize cash flow; the idea being that buyers can then use the 'deferred' principal money they aren’t paying on their home to pay off higher interest-revolving debt, such as credit card debt, automobile loans, etc.
A Simple Cost/Benefit Analysis
The benefits to this type of loan are twofold. First, they create a manageable monthly payment for homebuyers during the deferment period. Second, they enable borrowers to leverage cash flow to acquire additional property in an escalating market.
The monthly cost to own a home may be lower initially, but the backend of a 'Principal Deferred' loan can be treacherous. For example:
- A $232,000 ARM loan @ 5.6250% with a five-year 'Interest Only' option requires a payment of $1,087.50 during the first 60 months. On the 61 st month, the payment will increase $722.37, for a total of $ 1,808.87. Let’s say interest rates rise 2.5% during the first five years. Payments will correspondingly ascend to the payment cap. A fixed rate mortgage (which is locked against market fluctuation) will increase $354.55 for a total of $ 1,442.05.
The risks are also twofold. When rates inevitably rise, handling a higher payment can prove too difficult on a fixed income. Couple that with a broad flattening of appreciation, and payments end up feeling more like 'rent' with limited returns than the appreciating asset a homeowner borrowed money to purchase in the first place. Life has a way of keeping us on our collective toes, and any major financial event – such as a lost job, sudden health issue, death, divorce, college, wedding – can cripple those who have decided to go the route of the 'Interest Only' loan.
Avoid the End of Deferment Trap
At the conclusion of the deferment period, lenders begin to require payment toward principal along with the interest to eliminate the debt. At this time homeowners begin to pay off the actual loan amount they borrowed. Everything paid up until this time was interest, or put another way – the money a homebuyer pays a lender for the right to borrow his/her money. A steep payment increase could force you to refinance into another 'Principal Deferred' loan at a higher loan amount (incurring additional expenses). Otherwise, if the payment shock is too much for your budget, you could sell your home, incurring transaction expenses, or lose it through foreclosure.
Banks will foreclose on property that has increased in value if homeowners are unable to meet their monthly obligation or re-qualify for a new loan. It then becomes that much more difficult to qualify for another loan, especially if homeowners are generating the same income while interest rates rise. Monthly debt-to-income ratio may prevent them from qualifying for a new loan if they exceed the percentage limit permitted by their lender.
Many borrowers mistakenly link the expiration of a 'Principal Deferred' period with the next rate adjustment of an ARM. If ill planned, this blunder can cost thousands of dollars in refinancing expenses and an unexpected jump in your monthly payment.
Is an 'Interest Only' loan right for you? It depends largely on two factors:
- Your degree of real estate market savvy. If your understanding of the various economic factors that influence the dynamic real estate market is paltry at best, you are a target for the host of lenders who are more than willing to lend you their money. If you are considering this type of loan, do so with caution and full disclosure of the facts.
- Your reason for buying. In a hot seller’s market, 'Interest Only' loans can reap a sizeable reward as a short-term investment, as you pay minimal monthly payments and can turn around in 2-3 years to sell your rapidly appreciating home for a profit. However, if you are considering obtaining this type of loan for a property that you intend to call 'home' for a long period of time, ready yourself for the formidable increase in monthly payments once the deferment period ends.
While sound financial advice always returns in some way to clichéd common sense (never spend more than you have, pinch your pennies, etc.), most Americans don’t have hundreds of thousands of dollars sitting around with which to offer 100% cash for a home purchase. In most cases, a loan is required. When it comes to the 'Principal Deferred' Loan, clearly identify your reasons for buying; keep a close eye on interest rates during your deferment period; know the right time to sell, and do your best to create substantial savings in the meanwhile.
Information provided by Jon Kitchens, Mortgage Broker with Central Banc in Lake Oswego, Oregon. Please send inquiries to firstname.lastname@example.org.
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