Interest Only Loans

(and proctological exams)

Equity loans are hot right now. Home equity loans are fueled by a shortage of existing homes on the market and cheap mortgage money. In 2004, equity in homes climbed across the nation with loans getting cheaper and more competitive. The National Association of Realtors states that existing-home prices rose 8.8 percent from the fourth quarter of 2003 to the fourth quarter of 2004.

According to the California Department of Corporations, "A growing number of consumers are betting that home values will continue to appreciate as they take on mortgages that sharply lower their monthly payments but require them to shoulder far more risk."It is this risk that makes one pause when considering such a loan. This is true particularly in California where the interest only loans have blossomed over the past couple of years. Interest-only mortgages have surged as prices spike and mortgage rates plunge. The loans, which once were aimed at a small pool of affluent borrowers, have gone mainstream.

At Washington Mutual Inc., the nation's largest residential lender, such mortgages have accounted for roughly $1 billion a month since being introduced last summer. As mortgage rates fell to the lowest levels in decades, the loans were the most requested of all categories, said Gregory Sayegh, a senior vice president in the Irvine office. "We've seen a dramatic shift over the past 30 days," he said.

This type of mortgage, designed for buyers who intend to live in their homes for less than the length of the loan, allows borrowers to make lower payments than a traditional mortgage because none of the monthly payment goes toward the principal. Interest rates generally are up to 1 percentage point lower than fixed-rate mortgages, and the full payment is tax-deductible.

Typically, payments on a 30-year interest-only mortgage at 5.5% on a $500,000 home would be set at $2,292 a month, compared with a fixed loan at $2,839. That represents a monthly savings of $547. After five years, when repayment of the interest-only mortgage typically converts to an adjustable rate for the last 25 years of the loan, the borrower could have saved about $33,000, which might be used to pay for a child's education or to invest in other ways.

In a traditional mortgage, part of each payment is applied to the principal of the loan. Using the same example, a borrower after five years would have accumulated about $38,000 in equity, which also could be tapped for other uses through another loan.
"The question the consumer has to ask is: Am I further ahead [with an interest-only loan] rather than having the money sit in equity?" said Brad Blackwell, a senior vice president at Wells Fargo & Co. No group tracks the use of the loans. But Blackwell said interest-only loans, though they make up only about 5% of overall volume at Wells Fargo, are rapidly gaining in popularity.

"What's driving demand is that people are saying, 'I don't know if I'll be in the house for three to seven years. Why pay a higher rate of interest to lock in a rate for 30 years when I know my circumstance will be changing?' " said Craig Cole, a senior vice president at Union Bank of California, where use of interest-only loans also has soared.

But the loans could leave borrowers worse off if home values should stop rising or decline. At the end of the interest-only period, generally five to 10 years, consumers could be left owing more than the home is worth. Even if prices keep appreciating, analysts said, borrowers may need to refinance to more-favorable terms when the loan's interest rate becomes adjustable.

Interest-only loans, which have been around for about a decade, generally appeal to wealthy buyers who need large loans to purchase expensive homes. Those borrowers usually know they plan to move into another home or to refinance before the loan is repaid. The loans now are pitched to a broader audience as a way to buy more house for the money and to offset rising prices.

"No one is talking about the risks," said Keith Gumbinger, an analyst at HSH Inc., a New Jersey firm that tracks the mortgage market. "Markets do turn around and turn around uncomfortably, and not paying equity on a home means a borrower will still owe a lot of money down the road."

But many borrowers have found an interest-only loan too good to pass up. A similar product based on the concept also is gaining considerable steam as a method to purchase homes. Borrowers pay only interest on a line of credit for 10 years that can be used like a checkbook to pay off the home or to make other purchases.

For borrowers who are diligent and live within their means, interest only loans may make sense in some cases. For others, though, the risks far outweigh the benefits and these people who do well to check into other loan options.

Fiction: Interest only loans are quality investment tools for people who never want to own a damned thing. There I said the "D" word. Is this considered a dirty word anymore? We're on the Internet so I'd say no. Now, interest only loans are basically inventions to disconnect the cash in your wallet from you. You don't get anything in the end except for perhaps a proctological exam. And, if that is what you're into then who am I to judge.