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The Dangers of Interest Only Mortgages

Jun 27, 2008
A lady who went through a divorce had always relied on her husband to take care of the bills and manage the household finances. Once she was on her own, out of pure carelessness she forgot to make a couple of payments on some credit cards which caused a dramatic drop in her credit score. When she needed to purchase a car that would handle the needs of a single mother, the interest rates she was offered were so high that she opted to use a home equity loan to purchase the vehicle. She was sold on a variable rate interest only loan that gave her an extremely low payment but she was never told how the loan actually worked. Now, five years later, she still owes the original $30,000 that she borrowed and has a vehicle that needs to be replaced. She can't consider walking away from the loan or she could lose her house.

Another lady decided to refinance to consolidate some debt. Later, after running up some more debt due to family illnesses in another country which required time off the job and costly travel, she added a home equity line of credit. Both loans offered the interest only option. Again it was never explained how these loans work so she has spent several years thinking she had a nice low payment without realizing that her principle was not going anywhere.

Too many people simply don't understand lending in general, so to put a somewhat complicated loan in front of them without covering all of the possibilities is unfair at best and disastrous at worst. To spend years paying on a loan with a balance that never declines makes you very popular with your lender, but does nothing to help you eventually own your property outright.

Interest only means exactly that. You pay only the interest on your loan so the original principle is untouched. The loan still has to be repaid eventually and at some point will have to become fully amortized, meaning that you will have to pay enough to repay the loan in full by the end of the given term. On a 30 year mortgage, if the loan becomes fully amortized after 10 years, you would essentially have 20 years left to repay the loan. Since the principle has never been touched, it is the same as if you took out a brand new 20 year mortgage on your property. The difference in payment can be dramatic.

Using the example above, let's assume that you borrowed three hundred thousand dollars. Most interest only loans are variable as well which usually adjust at the same time that they become amortized. In this case, the loan was originated at 5.75% and we will figure that it adjusts upwards by one point after 10 years to a rate of 6.75%. For years one through ten your payment would be $1437 per month. But after ten years, your payment would jump to $2281 per month, an increase of over $800. Considering that rates are exceptionally low right now, it is entirely possible that future rates could be much higher. Should they climb enough to make your rate 11.75%, your payment would be $3251 per month. You better be making a lot more money by then or you could find yourself being forced to sell the house.

Of course the lenders will typically say that the borrower should not have signed something they didn't understand and that everything they need to know is right in the paperwork. To a degree this is true. You should never sign anything you don't understand, but at the same time you develop a relationship with your mortgage broker and consider this person to be an expert as well as an advisor. You rely on your loan officer to steer you in the right direction.

Unfortunately, by relying on someone who is relying on you for his income, you have put your financial future in the hands of someone facing a very basic conflict of interest (no pun intended). If you don't close on a loan, he doesn't get paid. I'm not trying to say that there are no loan officers that can be trusted. You just have to be careful. It's just a very competitive business and some people will use any edge they can find to make money.

To add to the issue, you are qualified for the loan based on the interest only payment. This allows you to buy a much more expensive house than you can really afford. These interest only loans as well as some other creative loan products are a big part of what fueled the runaway real estate bubble that has since burst. The individual that bought into a payment they could barely afford with the intention of selling the house in a few years for a huge profit is now stuck in a home that isn't worth anywhere near what they paid for it. Adding insult to injury, the balance hasn't dropped a dime. Of course in this instance it's a bad business decision rather than a lack of understanding of the loan product.

There are reasons to do an interest only loan. A investor that is buying a run down house to repair and resell for a profit might choose the interest only option to allow more cash flow to spend on the repairs so he can flip the house more quickly. There are some other scenarios where it might make sense as well, but to take the loan just because of the allure of the low payment can end very badly for you.
About the Author
Kevin Maher is the Agency Liaison at Debt Management Credit Counseling Corp (DMCC), a 501c(3) non-profit charitable organization offering free financial and budgeting education across the USA. For information call 866-618-DEBT or visit http://www.dmcccorp.org. Kevin's email is kevin@dmcconline.org
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