INTEREST-ONLY LOANS

Many buyers have found themselves competing for the same property, often having to offer more than the list price in order to have their contract chosen by the seller.  Potential buyers with less than perfect credit or with high debt are looking for alternatives to traditional loans. Mortgage companies have also responded to the current real estate market by creating a variety of non-traditional loan programs to suit today’s buyer.     

Over the past year or so, interest-only loans have received a lot of press – both good and bad.  Interest-only loans have become very appealing to buyers who may not normally be able to afford the type of home they are looking for.
 

What is an interest-only loan?

An interest-only loan is a loan that allows the borrower to pay only interest for a specific period of time.  The monthly payment does not include repayment of any principal, although borrowers may make such payments if they wish.

Like traditional mortgages, interest-only loans come in many different forms.  The interest rate can adjust annually or be fixed for a specific period of time (typically five, seven or ten years) before becoming variable.

These types of loans have become very popular in recent years.  In recent years, approximately 60% of borrowers have decided on interest-only mortgages over more traditional options.

ADVANTAGES & DISADVANTAGES OF INTEREST-ONLY LOANS

Advantages:

• Interest-only loans offer borrowers increased buying power since monthly interest-only loan payments are lower than traditional loans.
• Borrowers can leverage the money they save and invest it in high-yield investment vehicles.
• Borrowers can use the money they save to pay down high-priced debt. “Borrowers can use interest-only loans to facilitate paying down credit cards, student loans and other monthly debt while rebuilding their credit,” says Ford.
• For borrowers with fluctuating income, interest-only loans offer flexibility.  When finances are tight, buyers can make payments towards interest only; when cash flow is better, they can make payments towards principal also.

Disadvantages:

• Since there are no principal payments required, the borrower does not build any equity during the interest-only portion of the loan.
• Once the interest-only period ends, borrowers must begin repaying the principal amount borrowed.  However, it must be paid back but in a shorter period of time.
• If your home value declines, your loan could become “upside down,” meaning that you would owe more than your home is worth.
• Borrowers with interest-only loans are “debt leveraging,” which means they are hoping that their income and/or property value goes up enough to cover the increase in the mortgage payment.
• If a borrower opts for an interest-only loan, he/she may miss out on locking in one of today’s low interest rates.

Ford says, “Most people stay in a home an average of 3.7 years.  This means that although payments go up after the interest-only period ends, most borrowers will have sold their home and purchased another,” making many of the disadvantages of interest-only loans irrelevant.”

When you decide you are ready to buy a home, the first step should be to find a real estate agent who will work for you. The second step should be to get pre-approved by a loan officer, which will help you when and if you are competing for a home.  During the pre-approval process, your loan officer can work with you to help you decide which loan program is right for you.    

Payment Caps & Negative Amortization

Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble.

For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap--leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it's always wise to speak with your lender about payment caps and how negative amortization will be handled.

FINANCING YOUR NEW HOME

• What is an interest-only loan?
• What are closing costs?
• When should I pay points on a loan?
• Can I deduct points on my income taxes?