Interest-only and deferred-interest mortgages are gaining increasing popularity, as owners like the idea of having the freedom to decide how much to pay against their mortgage each month.
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We’ve talked about many of these mortgage products at length, but below is a brief breakdown of some of the most common home loan financing products and how they differ from one another. Especially in this lending climate, you can’t be too careful. Read up.
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FIXED-RATE MORTGAGE
Overview: A mortgage with payments that remain the same throughout the life of the loan, because the interest rate and other terms do not change.
Advantages: Predictable payment, you know you will not suffer when interest rates rise.
Disadvantages: An initial interest rate that will be higher than an ARM, as will the mortgage payment itself; no benefit when market rates fall.
ADJUSTABLE-RATE MORTGAGE
Overview: A mortgage loan subject to changes in interest rates; traditional ARMs typically have a fixed period with adjustable period afterwards. That period is generally made up of either 1, 3, 5, 7 or 10 years.
Advantages: Low initial interest rate compared with a fixed-rate mortgage, payments go down when market rates fall.
Disadvantages: No stability, payments change over time, payments increase when home loan rates rise.
BALLOON MORTGAGE
Overview: A balloon mortgage is a loan that typically offers low rates for a short period of time (usually 5, 7, or 10 years); after that, the balance must be paid off or refinanced.
Advantages: Lower rates than fixed-rate mortgages.
Disadvantages: Will need to pay off in short time period, may need to apply for a mortgage refinance at a higher rate than you’d like.
INTEREST-ONLY MORTGAGE
Overview: A mortgage that allows the borrower to pay only on the interest during the first few years of the loan (this model can be either fixed or adjustable rate).
Advantages: Low monthly payments.
Disadvantages: Initial payments do not reduce the principal on the loan.
PIGGYBACK MORTGAGE (or 80/20 LOAN)
Overview: Two loans taken out at once, with the smaller, second mortgage loan usually obtained at a higher rate.
Advantages: Eliminates mortgage insurance (PMI) on the monthly payment, which would be required of you if you did not make 20 percent of the purchase price as a down payment.
Disadvantages: In some cases, the total monthly home loan payment can be higher than with a 100 percent loan plus PMI.
OPTION ARM
Overview: Special adjustable-rate mortgages that allow the borrower to pay a credit card-like minimum payment that is actually less than the interest owed.
Advantages: Flexibility, low monthly payments.
Disadvantages: Possible negative amortization - your debt increases instead of decreases over time, somewhat defeating the purpose of home ownership.
SOURCE: The News-Journal
Three years ago, the northern Nevada housing market experienced a boom that carried through until about six months ago, when it stabilized and left some homeowners in a difficult financial situation.
Sonny Lopez, a local loan officer, tells the Reno Gazette-Journal that he noticed an increase in the amount of foreclosures in the Reno/Sparks area in 2005. He believes the increase in foreclosures in this area is due to “the cost of living going up and the retirement not matching it.” he said, noting that the greatest group affected includes those in their 50s and 60s.
At this point, an investor comes in and offers the struggling homeowner money to move and pays off their Nevada mortgage, which is the remaining amount owed in the original purchase price of the house.
These investors end up buying the property for a lower rate than the market value and turn around and sell it for more. Although Churchill County does not experience this high number of foreclosures, Lopez advises struggling owners to refinance before falling into debt.
In essence, mortgage refinancing involves paying off an existing home loan to obtain a better interest rate or to spread out the duration of the mortgage loan, resulting in lower monthly payments.
Refinancing also allows borrowers to tap their home equity, or money they have paid on the principal of their home, to pay off other debts, such as credit cards. There are fees involved, and this is why loan officer Jane Capurro advises seeking out a reputable and licensed mortgage broker.
“If you’re having problems, you don’t want to get yourself backed into a corner,” said Capurro. “What you want to do is to work with a mortgage broker who you can be open and honest with,” she said.
Capurro advises against interest-only mortgage loans, as does June Young, president and director of Young & Associates Mortgage Services. She describes interest-only loans as a big, dangerous bet.
This process is a gamble because if the property value did not appreciate over that period of time, the homeowner cannot refinance and may be stuck paying more than they can afford. When searching for a fixed-rate loan in today’s market, Capurro identifies good fixed interest rates as falling between 6.0125-6.25 percent.
For some owners who need financial assistance, the best option may be home equity loans, which are like a second mortgage. These allow the owner to borrow against the amount they have paid toward the principal on their home loan combined with its appreciated value, providing the borrower access to these funds while placing their home as collateral.
Mortgage delinquency and foreclosure rates are on the rise, and the impact could be greatest on low-income families that took out higher-interest loans for risky borrowers, the Boston Herald reports.
U.S. Treasury Secretary Henry Paulson said the government wants guidelines for banks and savings and loans that will allow people to get a bad credit home loan “without taking unnecessary risks.”
“Expanding opportunities for more people to buy a home is a good thing. But we do not want Americans to become overextended and see their dream end in foreclosure,” Paulson said at a conference on the housing market organized by the Office of Thrift Supervision, a Treasury Department agency.
Some experts are concerned that the foreclosure spike may affect the banking system’s financial health.
There have started to be “early signs of credit distress” in financial institutions’ holdings of so-called “subprime” or bad credit mortgages, especially in California, Richard Brown, chief economist for the Federal Deposit Insurance Corp., said at the conference.
In the housing boom that waned in the latter half of last year, many people took out subprime mortgages - high-interest loans for people with blemished credit records - with adjustable interest rates.
When mortgage rates rise, as happened last spring, it can raise monthly payments for people with adjustable-rate mortgages, creating a strain if they stretched to buy a home and don’t have a financial cushion.
William Longbrake is among a minority of experts “who believe the worst is still ahead in the housing market” for home prices to continue to fall.
“There is worse to come. … The bottom is probably still many months ahead,” Longbrake said. He noted that the rise in delinquency and foreclosure in subprime mortgages particularly affects low-income families.
Defaults could snowball in the coming months, a situation that bears watching. The Mortgage Bankers Association reported in September that mortgage foreclosures climbed in the second quarter as higher interest rates and energy prices made monthly payments harder for some homeowners.
The percentage of mortgages that went into the first stages of the foreclosure process in the April-to-June quarter rose to 0.43 percent, up from 0.41 percent in the first quarter and the highest level in just over a year. Foreclosure rates were highest for subprime borrowers.
Also, banking regulators directed lenders to fully explain the interest-only mortgage risks and the drawbacks of other nontraditional mortgages. Such mortgages have exploded in popularity in recent years and raised concern that there could be a sizable number of defaults if borrowers cannot meet rising mortgage payments.
The regulators also said banks must make sure the loans they made were “consistent with prudent lending practices, including consideration of a borrower’s repayment capacity.”
Record numbers of people have taken out non-traditional mortgages, loans with lower initial payments or other options designed to help buyers with limited resources overcome sky-high home prices.
But these loans - which in some cases are considered predatory by consumer advocates - come with higher risk. Not only risk to the individual buyer, but to the economy as a whole.
Comprising less than 1 percent of the home loan market in 2000, estimates are that as many as a third of all mortgages currently are non-traditional loans, according to the Washington Times.
Additionally, although industry experts say there is likely a correlation between high-risk mortgages and foreclosures, “statistics on how many homes foreclose because of high-risk mortgages is hard to track,” says Fannie Mae Foundation Director of Public Affairs Albert King.
Experts told a U.S. Senate subcommittee that delinquencies on adjustable rate mortgages increased 141 percent in 2006 from a year earlier. Some estimate that subprime borrowers are 25 percent more likely to default on their loan. Still, lenders are filling what they perceive as a need in the marketplace.
Home buyers have several costs involved in mortgages. A payment includes principal and interest and also includes taxes and insurance. Altogether, this is sometimes referred to as PITI.
For our purposes, discuss the principal — the amount borrowed — and the interest, the amount the lender charges for the loan. How a homeowner repays the loan with interest is what determines the true cost of a home. Buyers have many creative ways to finance a home, rather than the so-called traditional 30-year mortgage. Here are four options, from the “safest” to the riskiest.
Interest rates on option-ARMs generally start between 9-10 percent.
If homeowners cannot refinance before the introductory rate expires, they could find themselves paying up to 15 percent interest. If a buyer has an option-ARM loan and sees their interest rate go up two points within two years, they could see their mortgage payment up by 30 percent.
Gary Herman, president of Consolidated Credit Counseling Services.com, counsels people who fall victim to overwhelming debt because of risky mortgages.
“The initial rate these mortgage lender quotes is almost always a teaser. It’s never spelled out for the borrower what the final payment ‘could’ be if the interest rate keeps rising,” he said.
Herman says many people don’t know what it will cost them over the life of the loan. The majority of Herman’s clients have credit card debt and also a second mortgage loan.
“A client asked me to talk to a financial service for them about what their final payment could be and what they would actually pay for the loan. I called them up and asked them for the bottom line and to fax me the paperwork. The guy laughed at me and said that if they knew that they wouldn’t take the loan,” he said.
The upside? ARMs give consumers with credit problems and no savings a way to finance housing. But there are other choices. Fannie Mae offers a 40-year fixed mortgage, which helps consumers avoid some of that term-interest payment. It helps make the monthly payments more affordable.
Whatever you do, be careful with these risky options. There is little room for error, and you don’t want to end up strapped for cash when things go awry. You need that security blanket.
Are interest-only loans necessarily bad?
They can be at times, and often are, under the wrong circumstances for a particular applicant. But Bob Bruss, a real estate broker and syndicated columnist, believes that in some cases, they can work out fine.
In his most recent Q & A session, he addresses the ins and outs of the interest-only mortgage — something many people around the country have gotten quite familiar with over the past few years — and not always for the best.
Q: I have around $300,000 equity in my home. At the current remaining term I owe only about $34,000 on my mortgage. Although I am a retiree and in good health, I am “only” 64, so a reverse mortgage won’t give me much because I am too young.
I have a decent retirement income, but not enough to afford to go with my friends on cruises and afford other frivolous expenses. My suggests I get a 30-year fixed-rate mortgage with “interest-only” payments for the first 10 years. There is no negative amortization, which you often warn about.
He says I can easily afford the monthly payments, even after they “adjust” in 10 years to pay off the home mortgage loan in 20 more years. My children advise against it. What do you think? Should I go ahead with it?
A: Go for it and enjoy your home equity. Your children probably know you will be spending their inheritance and (at least subconsciously) may want to discourage you from fully enjoying your retirement while you are still in good health — or they just fear interest-only mortgages out of habit.
There is nothing “all bad” with an interest-only mortgage that doesn’t have negative amortization. The mortgage option you describe sounds pretty ideal as long as you can afford the payments on your retirement income, both now and 10 years down the line (when many people don’t plan ahead for) when the monthly payment adjusts.
The type of home mortgages that get homeowners into financial trouble in a hurry are the so-called “option ARMs,” where the monthly payments are so low they don’t even take care of the interest. When that happens, the lender adds the unpaid interest to the principal, resulting in negative amortization where the borrower owes more than the original balance.
That’s what you need to watch out for.
Those that take the interest-only mortgage route typically do so for a reason: they wish to keep monthly payments low for a few years.
Let’s take the example, therefore, of a couple that have been paying just interest on their home loan for five years. Once this term is over, is it better to sell the home, make a profit and pay off debts on credit cards; or consider mortgage refinancing and remain in the residence?
Certified financial advisor, Don Taylor, has an answer.
The mortgage refinancing debate: Refinancing now will start the clock over on a 30-year loan. Over the last five years, one’s house may have increased enough in value to let you do a cash-out refinancing to pay off credit card bills and other nuisances.
Moreover, the longer loan maturity at today’s solid mortgage rates could leave you with a lower monthly payment than you have on your existing mortgage.
Selling the house, using the profits to pay off your debts and moving into another home is always an option, but it often involves a steep price. Between real estate commissions, moving expenses, closing costs and redecorating the new place, you could spend a sum that dwarfs your outstanding credit card debt.
With an interest-only loan, you’ve kept mortgage payments about as low as they can get without negative amortization on the mortgage. If you were in a 5/1 interest-only adjustable-rate mortgage and you’re facing the first interest rate adjustment after five years, it’s easy understand why you’re looking for alternatives to your current loan.
Just take your time to consider all options and don’t be scared off by adding years onto your mortgage if refinancing is the route you select.
It should come as no surprise that the most significant fear borrowers possess involves the affordablity of their monthly mortgage loan bills. But what if we told you there was a way to greatly reduce these payments each month.
Is that something you would be interested in?
We’re speaking of interest-only home loans. Before you get too excited and sign on the dotted line for these resouces, however, let’s discuss the details of these adjustable-rate mortgages …
When you take out a traditional mortgage, you pay the lender a monthly amount that’s a combination of principal plus interest. The principal goes to repayment of the money you borrowed; the interest is what the financial institution charges for the use of the money.
However, an interest-only mortgage allows you to pay only interest every month for a fixed period of time - usually the first five to 10 years. Then, depending on the term of your loan, you have 20 to 25 years to repay all of the principal, plus interest.
You’re allowed to pay money toward the principal during the interest-only period, but make sure your interest is recalculated on the new balance.
An interest-only mortgage could be ideal for you if you are short of cash, but want to purchase a home in anticipation of an improvement in your financial circumstanes.
Also, consider mortgage refinancing with an interest-only loan if you’re experiencing a temporary fiscal squeeze - if, for instance, you or your spouse has chosen to go back to school, or one of you has decided to take a few years off with your children. Paying only interest for a few years could help you remain in your current home, even though you can’t make your conventional mortgage payments for the time being.
For example: you have a mortgage of $200,000, with an interest rate of 4.75 percent. With an interest-only mortgage and no principal payments due for five years, your mortgage payments for the first five years will be just $791 a month. With a regular five-year adjustable-rate mortgage and the same interest rate, you would pay about $250 more per month.
Because interest payments on your mortgage are generally tax deductible, you may be able to deduct 100 percent of your monthly payment, as well. Consult your tax advisor to confirm whether you are eligible to do so.
But remember: Monthly bills will rise tremendously after the initial five or ten year period. Only consider these options if you’re prepared to such an increase down the line.