Interest-only mortgages are spreading like wildfire. They seem to be the answer to rising home prices and incomes that can't keep up. You can buy "more house" and get a big tax break while having a low mortgage payment. I mean, who wouldn't want one?
Well, a lot of people take out these kinds of loans when they shouldn't. Some people do well with interest-only mortgages, but most people should avoid them because they are risky. However, the number of interest-only loans is rising quickly.
Take a look at San Diego. A study by LoanPerformance, a San Francisco-based real estate information service, found that in 2004, almost half of all mortgages had to be paid off in the first few years by paying only the interest. Could this be related to the housing market in some way? You bet it does. Are home prices going up more quickly than incomes and salaries? Yes, they are. So how can someone buy a house in a market where houses are so expensive? You guessed it: a loan that only pays interest.
Interest-only loans were first made for more experienced investors who wanted to increase their income by putting the part of their payment that would have gone toward the principal into investments with higher returns than the rate at which their home was appreciating. Most of the time, these types of investors have more assets and better financial habits than most, so they are less likely to get into trouble with this kind of loan.
Borrowers who are trying to get out of debt use interest-only loans these days. What they're doing is getting more debt for their money. They're borrowing more money but keeping their payments (at least at first) low so they can compete with other buyers in markets where sellers have the upper hand. Here are some of the risks that such borrowers might face:
If the principal balance isn't going down, then no equity is being built. If home prices stay the same during the interest-only period and the borrower needs to sell, he'll need to be able to pay sales costs with whatever equity is in the house, if there is any. Remember that the borrower is in charge of mortgage amortisation, but not appreciation.
If home prices go down, the borrower could end up "upside down," which means that the mortgage balance on the property could be more than what it's worth on the market. In this case, the borrower would have to pay the costs of selling the house and the remaining mortgage balance. If they didn't, the bank could take the house away.
Borrowers should get interest-only loans because:
- People who want to make more money in the future and want to buy "more house" sooner rather than later.
- Whose incomes change with the seasons, who get commissions and/or bonuses, and who want to make payments on the principal when it's convenient for them.
- Who want to put their cash flow into investments with higher returns or pay down high-priced debt.
With an interest-only loan, make sure you know what you're getting into. Talk to your mortgage broker or lender to find out what could happen, and make sure you're borrowing money for the right reasons. You want to own your home someday, so it's best to start planning for it as soon as possible.
