This is from my favorite Personal Finance website,
Motley Fool
Quote:
Not in Your Best Interest
By Chris Mallon
October 18, 2004
In an article earlier this year, I discussed some pros and cons (mostly cons) of interest-only mortgages. In an effort to prolong the U.S. housing boom, finance companies are peddling these mortgages to the average homebuyer, setting everyone involved up for trouble down the road.
Traditionally the province of wealthy individuals looking for tax advantages, interest-only mortgages have become a panacea for homebuyers looking to buy, frankly, more house than they can afford. It's estimated that 10% to 15% of all new mortgages in 2004 were of the interest-only variety, compared with an historical average of less than 2%. With big lenders such as Countrywide Financial (NYSE: CFC), Wells Fargo (NYSE: WFC), J.P. Morgan Chase (NYSE: JPM), and Washington Mutual (NYSE: WM) (to name just a few) promoting these mortgages to average buyers, taking on an interest-only loan has become acceptable, and even somewhat chic. Even smaller banks, such as Provident Bank of Maryland -- a unit of Provident Bankshares (Nasdaq: PBKS) -- are in on this action.
The dangers of an interest-only mortgage are clear. Initial payments are artificially low (no principal), so when the principal amortization begins, monthly payments will skyrocket. The majority of people taking interest-only mortgages are stretching their monthly payments to the limit, betting that either their income or the house's value will rise, or both. Adding fuel to the fire, many interest-only mortgages are also ARMs, introducing the double whammy of higher interest rates to principal payments down the road. When payments start jumping, don't be surprised to see many of these houses hit the market, as overextended borrowers rush to get out from under the crushing debt. That's when you'll see the housing market decline, at least in some areas.
Here's an example. Let's assume that Johnny Homebuyer is approved for a mortgage payment up to $1,500 per month but needs a $350,000 loan. With an interest-only mortgage at an interest rate of 5%, Johnny can just barely afford it. When principal amortization begins five years down the road, if rates have moved just to 6%, he's looking at a new monthly payment of about $2,255. Better hope he gets a big raise.
In general, however, I wouldn't panic. Most people with interest-only mortgages today will simply be forced to refinance over a new 30-year period and cut back on the Starbucks (Nasdaq: SBUX). Not a great scenario, but not the end of the world either. |
And this from Business Week
[QUOTE]Why is the surge in interest-only mortgages so frightening? Because many people are using them to buy houses that they couldn't otherwise afford. The monthly payment on an interest-only loan is lower because there's no amortization of principal. So people can qualify for bigger loans and buy bigger houses. The availability of such loans has probably contributed to the upward spiral in home prices, as shoppers armed with cheap financing try to outbid each other for choice properties.
The trouble comes when the interest-only feature expires, which is often after 10 years. If it's a 30-year loan, then the entire principal has to be paid off in the final 20 years. So the monthly payment could abruptly jump by 50% -- even assuming no increase in the interest rate (nearly all interest-only loans have adjustable rates, so the borrower can get whacked if they rise as well).
WRONG USERS. Interest-only mortgages were designed for wealthy families who used the loans as cash-flow management tools and could, if necessary, pay off the entire sum by liquidating some stocks and bonds. They can also be a good choice for people who have irregular incomes and strong self-discipline.
Such families can pay interest only in the lean months, then voluntarily make big principal payments in months when they have lots of income. Other natural candidates: People who are quite sure that their incomes will be rising sharply, like young doctors just out of medical school.
Trouble is, the sheer numbers indicate that the loans are also being taken out by a much bigger sector of the public -- people who are struggling to get into a rising housing market and feel that they couldn't get the properties they want any other way.
"BUYERS HAVE NO IDEA." Often, interest-only borrowers argue that they will refinance or sell their homes before the principal payments start coming due. But the risks are high. If they refinance, the new payment could be higher than the old one. And if they sell, they need to hope that prices have kept rising. Otherwise, they won't even recoup all of their downpayment.
Lenders that make interest-only loans argue that there's little risk of a wave of defaults as long as the economy remains reasonably strong and housing prices don't crash. But even some parties that benefit from the rage for interest-only mortgages, like homebuilders, are wondering if the trend may have gone too far. "In most of those cases, buyers have no idea how they're going to pay" the higher payments that will be owed once principal payments begin, says William J. Pulte, founder and chairman of Pulte Homes (PHM ).
Buyer, beware, indeed.
[QUOTE]
