Risks of Interest-Only Loans
Scarsdale tax preparer Paul Herman of Herman & Company CPA’s has all the answers to your personal finance questions!
Not repaying principal, and therefore not building equity through debt retirement, means that an interest-only borrower is counting on market appreciation (price inflation) to help them own more of their home. Of course, this requires that prices increase while they hold the mortgage.
However, you don’t own the national realty market; you own a single home in a single neighborhood in a single town, and people will concede that prices can and do increase and decrease regularly on a localized basis. So what does this mean to the interest-only borrower? There is a danger in not reducing the balance. If prices should fail to increase during the interest-only period, and if the borrower should find a need to sell the home, they could potentially be liable for thousands of dollars in sales costs which would need to be paid out of whatever equity (in the form of the down payment) they started out with.
The more extreme side of the first risk, of course, is that prices actually decline during the mortgage holding period. If our borrowers finds themselves in that situation, coupled with a low down-payment, they could easily find themselves “underwater” — a descriptive term that means they’ll sell the property for less than the remaining balance of the mortgage. In that unhappy case, the borrowers cannot sell without somehow coming up with what would likely be several thousand dollars to satisfy the mortgage balance as well as any sales charges (commissions, inspections, etc).
We noted before that payments made in the early years of a fully-amortizing are largely comprised of interest.
Interest Rate Risk
All the examples so far have been based on mortgages with a fixed interest rate. Unfortunately, most of the interest-only loans being made today feature only short fixed interest periods, if any; some featuring adjustable rates which can change each month. If history teaches us nothing else, it’s that low rates inevitably rise.
Above, we discussed term compression and its effect on payments, which causes them to rise above what they otherwise would be when the interest-only period ends. Now, magnify that compressed repayment term with a jump in interest rates, and you’ve got a recipe for a fiscal catastrophe.
Figure this: you, the interest-only borrower, have been happily making payments at $600 for the first five years of your (for now) fixed-rate loan. All the while, interest rates have been rising from their near-40 year lows to what could be considered “normal” — about 7% — and your monthly payment climbs over 40% to $848 per month. If you should find yourself in a period of considerably higher interest rates when the fixed-rate and interest-only period ends, your rate could climb to 9% or more — in which case your monthly payment could jump to $1,000 per month, or more.
Also at the moment, liberal and flexible mortgage underwriting standards are allowing borrowers to borrow more money for the same income, because qualifying ratios have been greatly expanded. Theoretically, a borrower’s budget might already be pretty stretched to the limit — and that’s before a nasty rate and payment hike.
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