Should We Return To Straight Mortgages?
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My grandfather was always proud of the way he financed his home. Family lore says he bought a row house on a dirt road — in Brooklyn! It was an immigrant’s dream, financed with an interest-only “term” mortgage that lasted three to five years. At the end of the term you either paid off the loan or, more likely, signed up for another few years.
Term — or “straight” financing — pretty much came to an end in the 1930s because as homes and farms lost value during the Great Depression, loans could neither be paid off nor renewed. One result was the movement pioneered by the FHA toward long-term, self-amortizing mortgages which offered more security to borrowers during hard times.
Today self-amortizing loans, mortgages in which the entire principal is paid off during the loan term, are a given — but term loans are making a comeback. We don’t call them “term” mortgages, but in a practical sense that’s probably the best way to view today’s new crop of interest-only loans.
Around the country we have seen enormous increases in home values in the past decade. If you own real estate for five years or more the odds are overwhelming that you have an appreciating asset, one which simply reflects the growing imbalance between supply and demand seen in many communities.
Alternatively, 40 percent of all existing homes are bought by first-time buyers, people who tend not to be at their peak earning years or to have accumulated much in the way of savings. By definition, of course, they have no real estate equity to invest in a residence.
Interest-only loans address this issue by lowering monthly cash costs for borrowers. With an interest-only loan at $993 a month and 6.25 percent interest, it’s now possible to borrow $190,656. With 10 percent down, homes in the $212,000 range are suddenly approachable — homes which may be better located, bigger or with more amenities than less expensive offerings.
Since the interest is likely to be entirely deductible and the initial monthly cash cost is lower than with amortized debt, it’s easy to see how buyers can be attracted to such financing. No less important, many borrowers justify such loans on the grounds that only monthly payments count, not total debt. An interest-only loan is somewhat like “rent” in this view, only with the possibility for appreciation and better tax write-offs.
The catch is that interest-only loans are not without risk.
Such financing, for example, is often based on a fixed-rate, interest-only payment for five years after which the loan becomes a one-year ARM for the balance of the term. If the loan is then amortized, it must be amortized over 25 years, not 30 years. If future rates hit 7 percent, here’s what happens: Monthly payments for principal and interest after five years go from $993 to $1,497. At 8 percent, the new monthly P&I will be $1,635.
Will higher monthly costs be a problem down the road? Probably not for most borrowers — just think of what most borrowers earned five years ago. But what if incomes don’t rise or don’t rise much?
An alternative option is selling after five years or so — if home values rise sufficiently.
Can past home price movements guarantee future trends? No — there’s always risk in the marketplace.
I’ve recently heard that borrowers will “save” money each month with interest-only loans, an imprecise expression which may raise concerns with regulators.
Interest-only loans reduce monthly payment costs when compared with fixed-rate financing, however to say these lower costs are a “savings” is debatable. Why? An interest-only loan and a fixed-rate mortgage are different loan products. The term “savings” implies a benefit which isn’t there: The cost of the loan is not lower, instead borrowers are paying less per month because they have elected not to reduce the principal balance for some or all of the loan term.
There’s demand for interest-only loans, there are logical and reasonable arguments to be made for and against such financing, but in the end they’re merely loans past generations have seen before — and sought to avoid.
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Published originally by Realty Times on August 10, 2004 and posted with permission.
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