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When an Interest-Only Option Makes Sense
Experts suggest the interest-only feature may be appropriate in several borrower situations. A person who counts on getting large periodic bonuses may like this option as he or she can apply that money directly to the principal. The borrower must be disciplined enough to follow through when the bonus arrives.
Other borrowers prefer to make monthly payments into investments—rather than to principal—with the assumption that the investments will offer a higher return than the cost of the loan. Borrowers who are confident that their personal incomes will grow may choose the interest-only option, figuring that their rising salaries will let them grow into the later principal and interest payments.
Borrowers who are confident that the values of their homes will soar over the next several years may also select the interest-only option. They may hold onto the house just long enough to pull the growth equity from it when it sells, having avoided large payments while the equity grew. Some borrowers may plan to refinance later at a lower fixed rate once their equity has grown and the home’s value has increased.
Borrower Beware
There are those for whom this option might not be good. Joe Rogers, an executive vice president with Wells Fargo Home Mortgage, says interest-only would not be recommended for those borrowers who can barely afford the house they are in, those who have tendencies to shop compulsively or are free spenders by nature, or those who are buying in a market where home values are declining.
Rogers says the interest-only feature “helps consumers manage their home financing payments and build equity at their own pace, thus allowing them to redirect cash flow to maximize investment and savings contributions. As customers make principal reductions, this also reduces their monthly payment requirement—unlike a fully amortizing loan—and is a key feature of an interest-only loan.”
Understand the Loan Climate
The interest-only loan is only a feature on a mortgage that will, eventually, require that interest AND principal be paid in full. Private mortgage insurance may be required or possibly built into the payments if a homebuyer does not have 20 percent to put down. If the option is offered on an ARM, borrowers need to understand that the interest rates will be changing and their interest-only payments may go higher.
If the housing market takes a downturn, borrowers may be stuck with a large mortgage on a house that will no longer sell at that price. If they had to move, they would be stuck with finding additional money to pay off the mortgage. Investment income and prime lending rates may also fluctuate, which will affect the desirability of an interest-only option.
The National Association of Realtors sees the growing use of interest-only and other unusual loan products as a threat to home ownership. NAR President Al Mansell says there are “insufficient disclosures” being made by lenders on these “riskier loan products.” The Association plans to offer consumers an educational brochure about various mortgage products. Mansell advises consumers to seek out reputable third-party consultants, such as the Better Business Bureau, for information on lenders and loan products.
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Text by Maureen Blaney Flietner
© 2005 BobVila.com
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