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NOTE: IF YOU WANT THE CRITICAL FACTS ABOUT
INTEREST-ONLY WITHOUT ANY FRILLS, GO TO THE INTEREST-ONLY
TUTORIAL.
December 1, 2003
"You have been harshly critical of
interest-only loans. Are you claiming that they serve no useful purpose for
anyone?"
No, that is too sweeping a statement. My
complaint has been directly primarily at the way interest-only (IO) loans have
been marketed. Some prospective borrowers receive the impression that these
loans carry lower interest rates or can be paid down more quickly than mortgages
with fully-amortizing payments, or that the initial interest rate holds for the
entire IO period. I don�t like to see decisions based on misperceptions.
IO loans meet some legitimate needs. But before
explaining what these are, I want to take another look at the fully amortizing (FA) mortgage. I have belatedly come to realize that a major reason there are so
many misperceptions about IO is that borrowers don�t fully understand the FA
mortgage, which is what an IO mortgage is not.
Consider a 30-year fixed-rate loan of
$100,000 at 6%. The FA payment is $599.56. This is the payment that, if
maintained over the term of the loan, will pay it off completely, assuming the
interest rate does not change. The $599.56 has two parts. The interest part is
.06/12 times $100,000, or $500. The remaining $99.56 is amortization. It is
applied to the balance, which falls to $99,900.44.
This $99.56 of amortization in month 1,
and the gradually rising amounts in the months that follow, is the difference
between the IO and the FA mortgage. The FA mortgage has a forced saving feature
built into it. The borrower is required to save $99.56 in month 1, $100.05 in
month 2, and progressively larger amounts in all succeeding months. With the
same monthly outlay, the savings rise every month.
Since the borrower with a FA mortgage saves the
6% that he would have otherwise had to pay on the amounts amortized, he is in
effect earning 6% on his savings. The yield is risk-free to the borrower. For
the great majority, it is the best possible investment available anywhere.
When you take an IO mortgage, you pay only the
$500 in interest, and forego the forced savings plan built into the FA mortgage.
So the question then becomes, why would any borrower want to do that?
A Need to Qualify:
Some borrowers may qualify for a loan with an IO who could not otherwise
qualify. The IO payment is lower than the FA payment, reducing the ratio of
housing expense to income that lenders use in qualifying borrowers.
However, qualifying a borrower with an IO who
would not qualify with a FA mortgage is an artifact of somewhat archaic
qualification rules. These rules are becoming increasingly flexible, and my
surmise is that this rationale for the IO will disappear in time.
Anticipating Income Growth: It
is common for families to begin with a "starter house", then move into
a more expensive house as their incomes rise. This process of "trading
up" carries high transaction and moving costs.
If you are fully confident that your income will
rise, you can avoid these costs by skipping to the second house now. In the
short term, this will cause a cash flow strain, but the IO mortgage may make it
doable. Ask yourself whether you are comfortable with the risk that the expected
higher income doesn�t materialize.
Need for Flexibility: Borrowers
with fluctuating incomes may value the flexibility the IO mortgage gives them.
They can make the IO payment when their finances are tight, and when they are
flush they can make a substantial payment to principal. Ask yourself whether you
are disciplined enough to make that payment when you aren�t obliged to.
Attractive Investment Alternatives:
I know someone with a small but growing business that absorbs all his time and
all his money as well. If he borrows to meet his business needs, it will cost
12-13%, or about twice as much as he can earn repaying his mortgage. Taking an
IO mortgage allows him to borrow less to meet his business needs. It pays to owe
more at 6% if it allows you to owe less at 12%.
The risk is that if his business fails, he is
left with a larger mortgage. You need a lot of confidence in yourself to take
this route.
The same could be said of taking an IO in order
to invest in the stock market. It might make sense if you have confidence in
your ability to pick winners. But don�t get hustled into it by a
"planner" looking to earn a commission on both your mortgage and your
investments.
Copyright Jack Guttentag 2004
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