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Interest-only loans: Be wary
(St. Louis Post-Dispatch (KRT) Via Thomson Dialog NewsEdge) Jan. 22--Utahns are increasingly relying on interest-only mortgages to help them buy properties they otherwise might not be able to afford.
Utah has the 10th-highest share of the controversial loans among all states and Washington, D.C., according to a report compiled by Loan Performance, a San Francisco-based company that tracks mortgage activity.
Such loans, used by investors in a number of hot housing markets to purchase real estate as an investment, also are being taken out by families who want to reduce their monthly housing expenditures or stretch their home-buying dollar.
Borrowers who take out such loans can pay only interest and nothing toward their principal loan balance for an introductory period -- typically three to five years. They may also pay a lower interest rate during that period, which further drives down their monthly payment.
After the introductory period ends, however, payments rise dramatically because principal is added back into the monthly payment and the loan is re-amortized over the remaining term of the loan -- 25 years instead of 30 years, for example. The interest rate also is refigured based on market rates, which in today's environment would help push the monthly payment even higher.
Such loans can be valuable cash-flow tools for people who are savvy about their finances. But many advisers say most Utah families should avoid them.
"Don't pay attention to a mortgage broker who tells you everyone is doing it," said Jean Lown, a personal-finance expert at Utah State University. "If you're considering an interest-only loan, you might not be able to afford the home you want to buy. You might be better off buying a much less expensive home or a condo."
Just five years ago, the share of interest-only loans in Utah was just 0.9 percent. The share of such loans grew to 10.4 percent by 2003 and 26.4 percent in 2004. From January to September -- the latest data available -- the percentage of interest-only loans rose to nearly 30 percent, significantly higher than the national average of 24 percent.
Bob Visini, a spokesman for Loan Performance, said interest-only loans have grown in popularity in recent years among real estate investors in fast-appreciating housing markets such as Arizona, Nevada and California.
Interest-only loans can be a valuable financial tool to manage cash flow, especially for families who expect to make more money in the future or who plan to sell their homes quickly.
"If used over a short-term it can be a handy tool," said Steve Coombs, president of Utah Mortgage Loan Corp.
The problem is that many families don't understand just how high their mortgage payments can jump after the introductory period ends or that a prepayment penalty can cost them thousands of dollars if they decide to refinance.
Larry Stevenson of Riverdale learned that the hard way about how costly interest-only loans can be when he paid a nearly $5,000 prepayment penalty and several thousands of dollars in closing costs to get out of one after his monthly payment jumped from $700 per month to more than $1,000. Stevenson said he and wife Kerri have become outspoken critics of such loans and urge other Utahns to steer clear of them. "My advice to most people would be to stay away," he said.
Here's how such loans work: A monthly payment on a $200,000, 30-year, fixed-rate loan would be $1,136 at 5.5 percent. The payment remains fixed over the entire life of the loan.
For a 30-year interest-only loan at the same amount with a five-year introductory period, the payment could jump to as much as $1,900 per month once the introductory period ends, the loan is re-amortized over 25 instead of 30 years and the interest rate is adjusted to reflect market rates.
The rise in the popularity of interest-only loans prompted the Federal Reserve to issue a warning to banks in December that the loans pose a real risk to the nation's financial system. Although foreclosure information relating to interest-only loans is not available, the rate is thought to be higher than conventional loans.
Many lenders say they already are being more careful about promoting interest-only mortgages.
Scott Shelley of First Colony Mortgage in Provo said interest-only mortgages can be useful tools for financially savvy borrowers.
Ultimately, however, he isn't a big fan of interest-only loans because there is a risk that families won't be able to handle the higher payments after the introductory period ends. He tries to educate borrowers about the potential pitfalls.
"I'm really conservative," he said. "If someone says they absolutely understand it and really want it, I'd do it, but I wouldn't go out of my way to do one of these loans."
Al Bingham of National City Mortgage in Salt Lake City said he, too, tries to educate borrowers about the risks of interest-only loans. But even then, he says, families still want them.
"I am not a fan of them. Only a very small percentage of people who take out these loans really understand them. People are just looking at the [low] initial monthly payments. The best thing we can do is educate them. But if they decide to take out of these loans, it's their choice."
AVOID INTEREST-ONLY LOANS IF . . .
--You might have to live in your house longer than you anticipated.
--You have not made much of a down payment or have no equity. Or you are struggling to make the initial monthly payment.
--You don't understand much about mortgages and are not clear about the terms of your loan.
--You are unsure if you will have the money to cover your monthly mortgage payment when the payments rise after the introductory period.
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