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Interest Only Loans – Are They Right For You?

By: Investor Solutions

By: Investor Solutions

On my commute to work one morning, I noticed an almost illegible sign at the front of a house. The sign turned out to be a “For Sale” sign and I decided I would amuse myself by calling and finding out how much they were asking for the home. The house was on a huge lot, on the water, in a great neighborhood but it needed a lot of TLC. I wasn’t ready for what I was going to hear come from the other end of the phone. The realtor started by saying, “Nine and a half”. Now, for the split second before the realtor finished her sentence, I thought to myself, “There is nothing that this lady can follow the, “nine and a half”, with that I could possibly afford.” Sure enough, her next two words were “million dollars”. I tried to act interested, but I was never really good at pretending. So I thanked the lady for her time, hung up the phone and laughed at how naïve I was. A few months later, the sign was gone and the house had been sold.

The point of my story is, how can people afford to buy houses in today’s hot real estate market? I presume that many of these homeowners have opted for interest only loans instead of conventional mortgages.

How Do These Loans Work?

Interest only loans are not actually loans. Interest only is an option you can add to your loan that that allows the borrower to pay interest only for a set period of time (5, 7 or 10 years), as detailed in the loan agreement. Let’s assume that you take out a 30-year mortgage with interest only for ten years. For the first ten years of the loan, you would pay interest only. At the beginning of the eleventh year, your payments will begin to include both interest and principal and will be considerably greater than what you paid during the first ten years. The principal will be amortized over the remaining 20 years.

The Problem

With these types of notes, one of the biggest questions for borrowers is knowing what their new interest rate will be once the interest only period has passed. The interest rate will adjust regularly according to the terms of the agreement, which vary among lending institutions. It is very important for consumers to be aware that one of the risks associated with the interest on loans is that the interest is usually variable.

In these situations, borrowers are exposed to rising mortgage rates when market rates increase. For example, your loan may state that your interest rate will be the current libor rate plus a margin of 2.25. (LIBOR is an abbreviation for the “London Interbank Offered Rate”. It is the interest rate offered by a specific group of London banks for U.S. dollar deposits of a stated maturity and is used as a base index for setting rates of some adjustable rate financial instruments). If the libor rate is 4% in say, month 40, your new interest rate will be 6.25% until the next adjustment period. Such terms make it difficult to forecast and budget for future payments.

Doing The Numbers

Let’s use a more modest example than the $9.5 million previously discussed. Suppose you took out a $750,000, 5.5%, 30-year interest only loan for the first ten years. Your monthly payments for the first ten years would be $3,438. In contrast, payments for a conventional 30 year fixed rate mortgage would be $4,258 monthly. Obviously, there is a significant difference in the payments. Based on our example, it looks like a pretty good deal to take an interest only loan, but as we know, the problem starts at year 11. With the conventional mortgage, your monthly payments would remain the same but with the interest only loan, monthly payments would be considerably higher because your interest rate will have been adjusted and principal payments will begin to be owed. Will you be able to afford the increase?

For the majority, interest only loans don’t make much sense. Sure you get mortgage interest and real estate tax deductions when you file your tax return, but the adjustable interest rate, shorter amortization period for your principal and uncertainty about the future in general make it a far less attractive option. Additionally, because no principal is paid and little to no money down is required at the time of purchase, many homebuyers will find that they owe the bank more than the home is worth should the real estate bubble burst and the need to sell their home arise.

Who Should Consider These Loans

There are, however, individuals who could benefit from an interest only loan.

1. High net worth individuals who want to maintain more liquid assets to invest for higher yielding returns. (But will they really invest the difference?)

2. Young professionals who are confident that their income will considerably increase by the time principal payments will start to come due. (What if optimism doesn’t translate into additional income?)

3. Short term homeowners who are more concerned with having cash on hand than equity in their home. (They plan on refinancing or selling the home before the interest only term expires.)

4. First time homeowners who don’t expect to own the home for more than five or six years and who can get a significantly lower interest rate by choosing an interest only loan. (What if the real estate market collapses?)

5. Real estate investors who purchase in areas where the real estate will appreciate more rapidly (Good idea if you plan to get in and get out)

I venture to guess that these individuals, the “exceptions”, have done their homework, consulted with financial professionals and devised contingency plans to mitigate the potential for disaster. They have enough liquid assets to make the payments when they come due, the foresight to refinance when it reaps a greater benefit and the business savvy to purchase in areas where there investment will bear fruit.

Obviously, homes such as the one in the introduction and surely those more affordable are being bought and sold every day. Interest only loans are one of the vehicles consumers are using to purchase these properties. Some people, I suspect, are not even sure of how they work or the potential disaster that can and will occur should their financial situation worsen or the real estate bubble burst.

Conclusion

When considering an interest-only loan, it is important to check with an independent third party professional who knows your situation and can give you sound advice. Those that are trying to sell you the loan are looking out for themselves. Your financial advisor or CPA is looking out for your best interest. They get paid regardless of whether you take out an interest-only loan and their recommendation can prove to be priceless.

As for my diamond in the rough, I think I will sit tight and wait for an affordable one to come along.