Interest-only mortgages can be risky

Interest-only keeps the payments down, but you are not paying for the home

The real estate market in the US has exploded in the last five years, especially on the East and West coasts. This has resulted in homes being priced out of the range of many would-be homeowners. Despite this, the percentage of Americans who own their own homes is the highest it has ever been. Some 69% of Americans are now homeowners. How is this possible?

The range of mortgage products available to borrowers has become more diverse over the years, and many mortgage options require small down payments and adjustable interest rates. Many such plans include a tiered payment schedule that increases the amount of the payment over the life of the mortgage. In the early years, the payments are lower, but as time goes on (and presumably, the borrower’s income increases) the payments increase. A fairly recent, and surprisingly popular, variation on this theme is the interest-only mortgage.

The interest-only mortgage is structured so that the borrower makes payments during the first few years of the loan only on the interest on the loan. No payment is applied to the principal. This period of time varies, typically ranging from one to five years. At that time, the mortgage payments will include a portion of the principal, the payment of which is spread over the remaining duration of the loan. The result of this is a loan that has substantially lower payments for the first few years and dramatically higher ones later. By keeping the payments low during the first few years, lenders are able to place buyers in homes they would otherwise be unable to afford. It is generally assumed that the buyer’s income will increase during the term of the loan by enough to allow them to be able to afford the increased payments that will come when the principal becomes a part of the monthly note.

This product has become quite successful, particularly in areas such as Washington, D.C. and San Francisco, where the price of housing has become nearly unaffordable for most everyone. The downside to an interest-only mortgage is that the buyer does not build any equity during the first few years of payments. In short, during this time the buyer isn’t actually paying anything for the house itself; they are only paying for the loan. Then again, the price of homes is increasing so rapidly in many cities that homeowners are building equity without even having to pay for it. In those cases, the buyers remain unconcerned as to whether they are purchasing their equity or not. Equity gained through an increase in value is the same as equity purchased through the mortgage; it’s just cheaper. The problem is that this only works if home prices continue to rise. What if they don’t?

Interest-only mortgages have variable interest rates and an increase in the rate will result in a higher payment. As rates are currently near record lows, payments will probably increase across the board in the next year or two. This may cause a lot of buyers who are already on the fringe of being able to afford a home, to default. Should this happen to a large number of buyers, home prices, which are already at record levels, could fall. This could lead to a collapse of the real estate market, as many buyers will find themselves with loans for amounts that greatly exceed the value of their homes. Owners who wish to sell may find themselves having to sell their homes at a tremendous loss and owners who wish to take out a home equity loan may find that they have no equity from which to borrow, making refinancing impossible.

This scenario is largely hypothetical, but it could easily come to pass. Buyers who are considering an interest-only loan should give some serious thought as to whether they can actually afford to buy the home, or whether it would be a better idea to buy a less expensive home instead.

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