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Here is
what you will learn in this tutorial:
1. What is an interest-only mortgage?
2. For what types of borrowers is it suitable?
3. What are the hazards you should watch out for?
4. What information do you need to assess an IO mortgage?
5. How do you get this information?
What
Is An Interest-Only Mortgage?
A mortgage is �interest only� if the
scheduled monthly mortgage payment � the payment the borrower is
required to make --consists of interest only. The option to pay interest
only lasts for a specified period, usually 5 to 10 years. Borrowers have
the right to pay more than interest if they want to.
If the borrower exercises the
interest-only option every month during the interest-only period, the
payment will not include any repayment of principal. The result is that
the loan balance will remain unchanged.
For
example, if a 30-year loan of $100,000 at 6.25% is interest only, the
required payment is $520.83. In contrast, borrowers who have the same
mortgage but without an IO option, would have to pay $615.72. This is
the "fully amortizing payment" � the payment that would pay off the loan
over the term if the rate stayed the same. The difference in payment of
$94.88 is �principal�, which go to reduce the balance.
For a
more complete illustration of the difference between an interest-only
and a fully-amortizing mortgage, see
Interest-Only Versus Fully Amortizing.
For What
Types Of Borrowers Are Interest-Only Mortgages Suitable?
Interest-only mortgages are for
borrowers who have a valid use for a lower initial required payment, and
are prepared to deal with the consequences.
Pay
Principal When Convenient:
Borrowers with fluctuating incomes may value the flexibility the IO
mortgage gives them. When their finances are tight, they can make the IO
payment, and when they are flush they can make a substantial payment to
principal.
Ask
yourself whether you are disciplined enough to make the payment to
principal when you aren�t obliged to.
Buy
More House: It is common for
families to begin with a "starter house", then move into a more
expensive house as their incomes rise. This process of "trading up"
carries high transaction and moving costs.
You can
avoid these costs by skipping to the second house now. In the short
term, this will cause a cash flow strain, but the IO mortgage may make
it manageable.
Ask
yourself whether you are comfortable with the risk that the expected
higher income won�t materialize.
Invest the Cash Flow: For most
homeowners, paying down mortgage debt is the most effective way to build
wealth. Nonetheless, some may build wealth more rapidly by investing
excess cash flow rather than paying down their mortgage. For this to
succeed, their return on investment must exceed the mortgage interest
rate, since that rate is what they earn when they repay their mortgage.
A valid
example is the young borrower with a long time horizon who invests in a
diversified portfolio of common stock. This should generate a yield of
9% or more over a long period. Another are business owners who might
earn a high return investing in their own businesses.
Ask
yourself whether you really will invest the excess cash flow, as opposed
to spending it; and whether you have a firm basis for believing that
your investments will yield a return higher than the mortgage rate.
I don't recommend it as a wealth-building strategy for most borrowers.
See
Is Unused Home Equity a Missed Fortune?
Quick Capital Gain:
An interest-only (IO) is the
instrument of choice in a quick turnover situation if you are trying to
maximize the amount of house you can buy, and are limited by your income. The IO
option lowers the required initial payment, which allows you to qualify for a
larger loan amount.
This is why buyers in markets
undergoing strong price appreciation, who are looking for quick capital gains,
gravitate to IOs � or to their big brother, the flexible payment (option ARM),
which has even lower payments in the first year than an IO. See
Questions About
Option (Flexible Payment) ARMs.
The more expensive the house they
can buy, the larger the expected capital gain. However, if you don�t need an IO
to qualify for the house you want to buy, it is not the best choice in a quick
turnover situation. See
Is Interest-Only
Best For a Quick Turnover?
Allocate Cash Flow to Second Mortgage: John Doe finances
his home purchase with an 80% fixed-rate mortgage (FRM) at 5.5%, and a
20% HELOC at 7.75%. The FRM is IO, and Joe uses all his available cash
flow to pay down the balance on the HELOC. This makes sense because of
the higher rate on the HELOC, and the possibility of future rate
increases.
Payment Responsive to Principal Reduction:
On most
IO loans, whether fixed or adjustable rate, the monthly mortgage
payment will decline in the month following
an extra payment. This is the only type of mortgage that has this
feature. On a conventional FRM, the payment never changes while on ARMs,
the payment doesn't change until the next rate adjustment.
Some borrowers find this feature
extremely convenient. For example, a home purchaser who must close
before his existing house is sold may want to use the proceeds of the
sale, when it occurs, to reduce the payment on the new mortgage. On many
but not all IOs, a large extra payment reduces the payment in the
following month
On some IOs, however,
the payment doesn't change until the anniversary month, and on others
it does not change until the end of the IO period.
If you are contemplating an interest-only
loan and find immediate payment adjustments in response to extra
payments a highly desirable feature, ask about it. See
When Will Extra Payments Reduce Monthly Payments?
What Hazards Should
YouWatch Out For?
The major hazard is being deceived into
accepting an interest-only mortgage that does not meet any of the
suitability tests described above. The deceptions are about alleged
desirable features of IOs that don�t in fact exist.
Borrowers can immunize themselves
against most deceptions by remembering one critical fact. If two
mortgages are identical except that only one has an interest-only
option, lenders view that one as riskier. The reason is that, after any
period has elapsed, the loan with the IO option will have a larger
balance.
Deception 1: An interest-only loan
carries a lower interest rate. Lenders usually charge a higher
rate for an identical loan with an interest-only option, for reasons
indicated above. I have never seen a price sheet in which a lender
quotes a lower rate on an identical loan with an IO option, though I am
told it happens; this is not a perfect market.
The deception arises from comparisons of
apples and oranges. Most interest-only loans are adjustable rate
mortgages (ARMs), and ARMs have lower rates than fixed-rate mortgages
(FRMs). ARMs with the IO option have lower rates than FRMs because they
are ARMs, not because they are IO.
Deception 2: An interest-only loan
allows the borrower to avoid paying for mortgage insurance. Since
loans with an IO option are riskier to the lender, the option cannot
cause the disappearance of mortgage insurance.
Any IO loans with down payments less
than 20% that don�t carry mortgage insurance from a mortgage insurance
company are being insured by the lender. The borrower is paying the
premium in the interest rate rather than as an insurance premium.
Deception 3. On an ARM with an
interest-only option, the quoted interest rate is fixed for the
interest-only period. It may or may not be. The interest-only period
is the
period during which you are allowed to pay interest only, usually 5 or
10 years. The period for which the initial rate holds can be as long as
10 years or as short as one month.
Where the initial rate period is 3, 5, 7
or 10 years, the interest-only period is likely to be the same. Where
the initial rate period is a month, 6 months or a year, the interest-only period
will probably be longer. These are the cases where deception is most
likely to arise.
Deception 4. It is less
costly to amortize an interest-only loan. This is patently
ridiculous, but some variant of it keeps popping up in my mail.
There is no magic connected to
amortizing an interest-only loan. A borrower who takes an interest-only
option but decides to make the fully amortizing payment instead will
amortize in exactly the same way as the borrower who takes the same
mortgage without the option. Read
Does an an Interest-Only Amortize Faster?
What Information Do You Need To
Assess An IO Mortgage?
ARMs have
the advantage of carrying a lower interest rate, and lower monthly
payment, in the early years than fixed-rate mortgages (FRMs). But
because the ARM rate is adjustable, it may rise in later years, and the
payment will rise with it. Intelligent decisions about ARMs, therefore,
require that account be taken of what might happen when the initial rate
period ends.
While
future interest rates are not known, we can make assumptions about what
will happen to rates; these are called interest rate scenarios.
Usually, we focus on rising rate scenarios, because those are the ones
we worry about.
For any
given scenario, we can calculate exactly how high the rate and mortgage
payment will go, and when it will get there. This is scenario
analysis. We can also calculate the total cost over any period
specified by the borrower. In assessing ARMs with an IO option,
borrowers will want to compare scenarios with and without the option.
When ARM
rates are much lower than FRM rates, shrewd borrowers may take an ARM
but make the payment that they would have had to make had they taken an
FRM. By paying the balance down faster, the cost imposed by rising rates
in the future is reduced. Hence, it is useful to perform scenario
analysis based on the assumption that the borrower pays at the FRM rate
for as long as that payment is larger than the ARM payment.
This is an alternative to an
IO, and based on the opposite premise. Where an IO attempts to minimize
the borrowers payments in the early years, for any of the reasons noted
earlier, the FRM payment option is designed to pay down the balance as
much as possible in the early years.
To see a
sample of rates/payments and costs on an ARM, with and without both the
interest-only and FRM payment options, click on Sample Rates/Payments and Costs.
How Do You Get This
Information?
You get it
in two steps. In step 1, you have your loan officer or mortgage broker
provide the essential data on the features of each loan you are
considering. To make it as easy as possible for them, print out and give
them
Worksheet of ARM Features.
Step 2
involves transferring the data on ARM features into the
ARM Tables calculator which will generate your tables.
Have
your data in hand before clicking on ARM Tables calculator above or
selecting the ARM Tables calculator on the Tutorials Menu.
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