September 2007 News Update

Three Risks of Interest-Only Home Loans:

Market Risk I

Not repaying principal, and therefore not building equity through debt retirement, means that an interest-only borrower is counting on market appreciation (price inflation) to help him own more of his home. Of course, this requires that prices increase while he holds the mortgage. Now, folks who follow the national realty markets are quick to point out that there hasn't been a broad decline in home prices since the Great Depression. However, you don't own the national realty market; you own a single home in a single neighborhood in a single town, and those followers will also concede that prices can and do increase and decrease regularly on a localized basis.

So what does this mean to the interest-only borrower? There is a danger in not reducing the balance. If prices should fail to increase during the interest-only period, and if the borrower should find a need to sell the home, he could potentially be liable for thousands of dollars in sales costs which would need to be paid out of whatever equity (in the form of the down payment) he started out with. According to the National Association of Realtors, typical down payments have fallen from 10% in 1990 to about 3% in 2007, so it's likely that at least some borrowers could be courting trouble here.

Market Risk II

The more extreme side of Market Risk I, of course, is that prices actually decline during the mortgage holding period. If our borrowers finds themselves in that situation, coupled with a low down-payment, they could easily find themselves "underwater" -- a descriptive term that means they'll sell the property for less than the remaining balance of the mortgage. In that unhappy case, the borrowers cannot sell without somehow coming up with what would likely be several thousand dollars to satisfy the mortgage balance as well as any sales charges (commissions, inspections, etc).

We noted before that payments made in the early years of a fully-amortizing are largely comprised of interest.

Interest Rate Risk

All the examples so far have been based on mortgages with a fixed interest rate. Unfortunately, most of the interest-only loans being made today feature only short fixed interest periods, if any; some featuring adjustable rates which can change each month. As this is written, low interest rates are the order of the day, with some short-term rates at or near historic lows -- but if history teaches us nothing else, it's that low rates inevitably rise.

Above, we discussed term compression and its effect on payments, which causes them to rise above what they otherwise would be when the interest-only period ends. Now, magnify that compressed repayment term with a jump in interest rates, and you've got a recipe for a fiscal catastrophe.

Figure this: you, the interest-only borrower, have been happily making payments at $600 for the first five years of your (for now) fixed-rate loan. All the while, interest rates have been rising from their near-40 year lows to what could be considered "normal" -- about 7% -- and your monthly payment climbs over 40% to $848 per month. If you should find yourself in a period of considerably higher interest rates when the fixed-rate and interest-only period ends, your rate could climb to 9% or more -- in which case your monthly payment could jump to $1,000 per month, or more.

Also at the moment, liberal and flexible mortgage underwriting standards are allowing borrowers to borrow more money for the same income, because qualifying ratios have been greatly expanded. Theoretically, a borrower's budget might already be pretty stretched to the limit -- and that's before a nasty rate and payment hike.