The Beauty of Interest-Only Loans — And The Beast
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There’s no doubt that the newest trend in real estate financing is the interest-only loan, a trend which needs to be examined with care by anyone who prefers to avoid poverty.
An interest-only loan is both what it seems and not what it seems. It’s interest-only debt for some or all of the loan term, but it’s also likely to be a form of “balloon” financing — a loan with a huge final payment, often as large as the original loan balance.
To see why, let’s compare a sample interest-only loan and a basic fixed-rate mortgage.
Imagine that we borrow $200,000 at 3.8 percent — that’s the six-month LIBOR index (2.3007 percent) when this posting was originally written plus a 1.5 percent margin. This is an adjustable-rate mortgage (ARM) where the rate can rise or fall. In the case of this mortgage, the initial rate is fixed for 10 years and the loan is an interest-only product during its first decade. After the first 10 years, the interest rate adjusts for the remaining 15 years.
For purposes of example, let’s also agree that the interest rate will not change after 10 years and that no points are being charged. Let’s also create a mythical 25-year fixed-rate loan at 3.8 percent. Here’s how the loans stack up.
In terms of monthly payments, the interest-only product costs $633.33 a month during the first decade while the fixed-rate loan with a 25-year term has a monthly cost of $1,033.71.
At the end of 10 years, the interest-only borrower has paid out $76,000 while the fixed-rate loan has cost the borrower $124,045 — a difference of $48,045.
The money paid out, however, is not the only issue to consider. At the end of 10 years the interest-only borrower still owes $200,000 while the fixed-rate loan balance has been reduced to $141,661.69. That means $58,338.31 has been knocked off the loan amount versus nothing from the interest-only loan.
If we compare the monthly cash saved in the first 10 years by the interest-only borrower ($48,045) with the principal reduction earned by the fixed-rate borrower ($58,338) we can see that the interest-only approach is actually more costly by $10,293.
In our example we have two 25-year loans. In the first 10 years rates and costs for both loan products do not change. However, for the remaining 15 years the fixed rate borrower will continue to pay out $1,033.71 per month while the story for the interest-only borrower is very different.
After 10 years the interest-only borrower still owes $200,000, a debt which must be paid out over the remaining 15 years of the loan term. At 3.8 percent the cost per month for principal and interest will be $1,459.41.
Over the 25 year term, the fixed-rate loan will have a total interest cost of $110,114. The interest-only loan? There was an interest cost of $76,000 during the first 10 years and an interest expense of $62,694 in the last 15 years, a total of $138,694. In effect, the premium for interest-only financing is $28,580 — a huge difference even if the interest-only rate remains unchanged during the life of the loan.
This analysis raises some questions:
Do most people have a loan for 25 or 30 years?
No. But when an interest-only loan is paid off during the first 10 years, the most-likely scenario, the entire debt remains outstanding. That means that compared with an amortizing loan there are fewer dollars from closing which can be invested in a replacement property or used for other purposes.
Why consider a 25-year fixed-rate loan when most people use 30-year financing?
For purposes of example only. With a 30-year term, a $200,000 fixed-rate loan at 3.8 percent interest — if there were such a thing — would have a monthly cost for principal and interest of $931.91. If the fixed-rate loan was paid off over 30 years the total interest cost would be $135,489.29.
Is interest-only financing a good choice for people with limited incomes?
If their income continues to be “limited” when the interest-only loan switches into phase two, the amortization years, the borrowers may be in trouble because of higher monthly loan costs. If a borrower has a good and growing income then the matter of higher monthly costs need not be a problem.
The example uses the same rate of interest for 25 years with the interest-only mortgage. Do you believe that interest rates will be essentially unchanged from today’s rates for the next 25 years?
I believe it’s more likely that web-footed fern people from the planet Norkvar VII will land in Iowa.
What happens if the interest-rate rises after 10 years?
In our example with a $200,000 loan, the monthly payment would increase from $633.33 to $1,479 (4 percent), $1,582 (5 percent), $1,688 (6 percent), $1,798 (7 percent), $1,911 (8 percent) and $2,029 (9 percent). If the loan has a 6-percent lifetime interest cap above the start rate (3.8 percent) then the highest monthly cost in the last 15 years of the loan would be $2,125. In all cases, of course, property taxes and insurance are extra.
Why not just refinance with a new, fixed-rate 30-year loan after five years?
This is possible, assuming that the property has sufficient value and that the borrowers can qualify for a new loan. However, since the principal balance has not declined, refinancing $200,000 after five years means that you effectively have a 35-year mortgage — a loan with much higher overall interests costs plus the expense of an additional closing. A $200,000 mortgage financed over 35 years at 3.8 percent has a potential interest cost of $161,921.32.
Converting to a 15- or 20-year loan might make more sense in terms of potential interest costs, however monthly payments will be higher than with 25- or 30-year financing.
Why not just re-sell the property as home prices increase?
First, home prices do not always increase. Second, if home prices do increase and a property is sold, the owners must move elsewhere. Will a replacement home be less expensive than the one which was sold?
Why worry about future monthly costs? With inflation we’ll be paying with cheaper dollars.
The value loss from inflation will be offset or exceeded by rising interest levels. If you want to benefit from cheaper dollars in the future, get a fixed-rate loan at the lowest possible interest rate and let the lender worry about inflation.
I hear advertisements saying that I can save hundreds of dollars each month with interest-only financing. Isn’t this true?
Here’s what’s true: With an interest-only loan your initial monthly cash payments each month will be — and be sure to read the rest of this paragraph — lower than with a self-amortizing loan of the same size and with the same rate and terms. However, the interest-only borrower has more debt for a longer period and thus higher total costs. And if rates rise, monthly costs and overall interest costs could be substantially larger than with fixed-rate financing. One way or another, Miller’s first law of financing holds true: The lender always collects.
Can you think of any cases where an interest-only loan might be attractive?
Yes. In a situation where (1) the value of real estate is reasonably expected to rise at or above the rate of inflation because local population growth is outstripping new home construction and the local job base is growing; (2) the borrowers have rising incomes; and (3) the borrowers faithfully prepay each month during the initial 10-year period to reduce future risk.
With prepayments allowed in whole or in part and without penalty, disciplined borrowers with good incomes and appreciating properties can effectively convert interest-only financing into ARMs with lengthy and cheap start rates. By making pre-payments and reducing the loan balance during the initial fixed-rate period, borrowers will owe less when the loan converts to ARM status or is refinanced. With less principal outstanding, the borrowers will have less interest than if the loan had remained at its original size.
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Published originally by Realty Times on November 30, 2004 and posted with permission.
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