Ethical Homes

I’m often asked about interest-only loans, which many buyers in this area are using to purchase new homes; I usually advise strongly against them, but for one recent couple with whom I was working, an interest-only loan actually made a lot of sense.

This couple had recently moved to the area so that the husband could attend law school, and the wife was looking for a job in the area. Their lender had advised them to wait until she had her new employment secured before securing a loan, so that they would have a lower debt-to-income ratio and thus be able to get better rates for their loan; other financial circumstances made waiting for too long unfeasible for them, however. In a situation like this, an interest-only loan actually makes a lot of sense; here is the email I sent to these buyers explaining why they might want to consider an interest-only loan:

Given your circumstances, you may want to look into an interest-only (IO) loan. I normally don’t recommend them to first-time buyers, because they can present some serious risks to buyers who don’t understand how they work, and first-time buyers tend to have so much new information to deal with that it can be easy for them to lose sight of those risks amidst everything else they are dealing with; your situation, though, is actually one of ones for which IO loans are ideally suited, because the risk for you would be naturally mitigated.

Take, for example, a 5-year fixed-rate IO loan, as compared to a “traditional” 30-year fixed-rate loan. Normally, a 30-year fixed-rate $200k loan at 6% would have a monthly payment of $1200. In the first month, $1000 of that payment would be interest, while the other $200 would go towards paying off the principal. Each month after that, the payment would still be $1200, but slightly less of that payment would be towards interest, and slightly more would go to principal, so that at, say, the end of year 5 the outstanding balance would be about $186k.

With the 5-year fixed-rate IO loan, however, the monthly payment for the entire 5 years is equal to the amount of interest for the first month of the corresponding 30-year loan—just $1000; none of those payments actually “pay off” the loan, however, so at the end of the 5 year period, you would still owe $200k, which technically would need to be paid off immediately in one “balloon” payment, although many buyers can arrange at the same time that they get the first loan for a second, traditional, loan to pay for that balloon payment, so that in effect their loan is IO for the first five years, and then switches to an adjustable rate mortgage (ARM) for the next 25 years.

While an IO loan allows a lower payment (or an equivalent payment for a higher-priced property), then, it has some obvious downsides:

1. It features either a sudden, very large payment after 5 years, or else a huge jump in monthly payments due to the switch from an interest-only payment based on a 30-year amortization schedule to a regular payment based on a 25-year schedule (since paying the same amount off in a short period of time obviously requires higher payments). Since the second loan is usually an ARM, and interest rates are expected to go up in the next few years, the second loan would probably have a higher interest rate to boot; the interest rate on an ARM is determined by adding a predetermined margin to some variable index such as the LIBOR (the interest rate that banks in London offer for deposits in US dollars), for example, so if the margin were 2.5% and if the LIBOR rate after 5 years were 5%, then the rate for year 6 would be 7.5%. The monthly payment in year six, then, could be the payment for a regular 25-year loan at 7.5%, or a little under $1500—a significant jump from $1000, and for many buyers, a large enough jump to cause them to be unable to pay their mortgage.

2. It costs more in the long run, since the interest portion of the payments for those first five years don’t decrease with each payment, as they do for a traditional loan. At the end of 5 years, then, a buyer using an IO loan would have paid $60k in interest, while one using a traditional 30-year fixed-rate loan would have paid just over $58k in interest.

   There’s also, again, the higher cost associated with the probable higher interest rates on the second, 25-year, loan. If rates over the 25 year life of the second loan average 7.5%, then you would end up paying a total of about $303k in interest over the full 30 years, vs. about $289k over 30 years for the fixed-rate loan. Most people in the DC area sell or refinance within 3-5 years of purchasing, though, so those would be worst-case numbers, and on the off chance that interest rates actually averaged 6% over the life of the 25-year ARM, the fact that you were paying off the house over 25 years rather than 30 years would actually end up saving you money—with the 5-year IO loan plus the 25-year ARM at 6%, you would only end up spending about $246k in interest.

   (Obviously, there’s a lot of math involved and a lot of scenarios to consider; this is another reason I don’t advise IO loans to most buyers, because it is very easy to only look at the best or the worst case numbers, rather than considering the entire picture when making the decision of which loan to use.)

3. It doesn’t directly build equity; after five years, the amount owed would be the original price paid on the home. Some people feel that this isn’t an issue in an appreciating market such as the one currently in DC, but even though all signs do point to continued rising prices here, there are never any guarantees that a market will continue behaving the way that it has in the past; an IO loan thus creates extra risk around the scenario where the buyer has to sell the property earlier than expected—if, in year 4, you were forced to sell (after graduating and getting a job in a new city, for example), and the market had actually gone down in those four years so that you could only get $185k for the property at that time, then you would need to come up with the extra $15k out of pocket, or face foreclosure.

Most buyers right now who are getting IO loans, then, are either not really thinking about what will happen at the end of the interest-only period, or else are planning on selling the property before the balloon payment becomes due or the higher monthly payments kick in, on the assumption that rising prices will give them enough equity to make it worth their while. For most buyers, however, I just don’t think that the greater risks produced by IO loans are worth it; again, although the fundamentals of the market do appear to be in place to sustain continued growth, there is no guarantee that that will happen, and an IO loan would, normally, greatly amplify the downside of a market downturn.

Your situation isn’t normal, however, for three big reasons that match up nicely with the main risks of the IO loan:

1. Your income will almost definitely increase once you finish law school, well before the increase in payments would occur; that means that, even if you don’t sell the house before the higher payments start, you would probably be able to afford those higher payments.

2. You have a fairly good chance of moving before the end of the interest-only period, so the risk of longer-term costs are minimized.

3. Your wife will probably be getting a job relatively soon. Many IO loans have a “flexible payment option”, which allows you to choose each month whether to make the usual interest-only payment, or else to pay more, with the excess amount being applied towards principal owed, which both builds equity and reduces the amount of interest that gets “wasted”; it’s not quite as good as committing to pay that principal up front, but only barely so. If, for example, your wife gets a job before you actually go to closing, and so you started making the full $1200 payment from day 1, after 5 years your balance owed would be $189k, rather than $186k for the traditional loan; in the big picture, that difference is negligible, while the lower “official” monthly payment would offset the lower income that you would have during the loan qualification process, so that you could still qualify for loan amounts similar to what you’d get on a traditional loan if your wife already had her new job.

Again, interest-only loans aren’t for everyone, or even for most people; at the same time, they are extremely useful for some buyers—especially people who expect their income to increase significantly over time, such as people in professional schools. IO loans with flexible payment options have an even broader appeal, allowing people with significant but fluctuating income (e.g. investors and the self-employed) to better manage their monthly cash flow. If you fall into one of these categories, I’d be glad to talk to you about how an interest-only loan could apply to your situation.

[Update 8/19/05: The day after I posted this, the non-profit Center for Responsible Lending published their Specialty Mortgage Brochure (PDF), which also cautions buyers about the risks of interest-only option loans while noting that they are well-suited to certain buyers.]