People have been rushing to buy real estate in South Florida and elsewhere. Houses that were once priced well beyond the means of potential real estate investors have suddenly become affordable. The reason? It is the new financing method called interest-only loans.
Interest-only loans have become increasingly popular because they afford investors the chance to reduce monthly mortgage payments, while keeping that portion that would normally go toward principal either in the bank or in some kind of investment vehicle where it can continue to earn on a compounding basis.
With traditional mortgages, the monthly payment consists of an interest portion and a principal portion; over time, the amount going to the interest drops and the amount to principal increases until the loan is paid in full.
But with an interest-only mortgage, you pay only interest in the early years of the loan; later on, principal payments kick in, too, at a higher amount than with a traditional mortgage because they're paid over a shorter period of time.
These interest-only loans enable you to borrow more than you could with ordinary loans because the monthly mortgage payment does not include any funds to pay down the principal, the money that was borrowed.
Once the interest-only period is over, the payment amount grows to include payments against the principal for the rest of the term of the loan. The new payment will be larger than it would have been if it had been fully amortizing from the start so that the same principal will be paid off at the end of the loan.
A whole range of interest-only mortgages have come on the market. Some adjust every time a bank's prime lending rate changes; others come with fixed rates for three, five, seven, or ten years before they are adjusted.
To understand how these interest-only mortgages work, we have to understand the conventional mortgage first. Let's take a conventional 30-year, fixed-rate mortgage. Today, these loans charge about 5.75%. We're going to round off that figure to 6% to make it easy.
For every $100,000 you borrow, you will pay about $600 a month. That $600 payment comprises two parts. At the start, you'd pay $500 in interest, and another $100 in principal. Over time, the principal payments reduce the debt. As the debt gets smaller, the interest payments drop as well. The reason? The payments are figured each month by applying the interest rate to the remaining debt.
Since the monthly payment is always $600, a smaller portion goes to interest each additional month and a larger portion to principal. There is a snowball effect. At the start of the mortgage's final year, when only $6,400 of principal is left, just $35 a month goes to interest, $565 to principal.
Now let's look at an interest-only 30-year mortgage for the same $100,000 amount, at the same interest rate.
With the interest-only mortgage, as has been noted, there are no principal payments for the first five, seven, or ten years. The monthly payment during this period thus is only $500, compared to the $600 on the standard loan. This is a full interest payment. The payment is fixed over five years. At the end of five years, the borrowers will be paying principle and interest for the remainder of the term. What we advise clients at that stage is to come in for a ''loan check-up,'' to see if there's new value on the property. If there is, perhaps it is time to take cash out and refinance into another five-year interest-only mortgage.
To get more specific: a conventional, 30-year loan for $150,000 at a 6% rate requires a monthly payment of $899.33. At the end of five years, the balance owed would be $139,581.54, and you would have paid the bank $53,959.80.
With the interest-only loan for the same amount at the same terms, the monthly payment would be $750. But after five years, the loan balance would still be $150,000 because you have not cut into the principal, and you would have paid the bank $45,000.
STRATEGY # 17:
CHOOSE AN INTEREST-ONLY LOAN, AND HAVE THE ABILITY TO PAY OFF YOUR MORTGAGE FASTER THAN WITH A MORE CONVENTIONAL LOAN.
With an interest-only mortgage you can actually pay off a home faster than by relying on the more conventional loans, by making lump sum principal payments annually, quarterly, or monthly. This affords you the ability to really chip away at principal, since a regular amortizing mortgage (although comprised of principal and interest), has less going to principal over the first half term of the loan.
One concern that people have about interest-only mortgages is the fear that they will be subject to much higher interest rates after the initial five- to ten-year interest-only period ends. But with interest rates at historic lows, many variable-rate interest-only loans are capped at 12% or less over the span of the mortgage. That is a rate that many Americans need not fret about.
One argument in favor of the interest-only mortgage has been that by the time the mortgage converts into one in which the full monthly mortgage payments have to be made (usually after five to ten years), the borrower's income will have increased enough to handle the higher payments. What is statistically more likely to have happened, however, is that the borrower has moved or refinanced by the time the principle payments kick in.
There are other benefits as well. The mortgage payment is based on simple interest while any return one gets on an asset investment is based upon compounded interest. As an example: interest as simple interest on $100,000 at 5 percent over five years is $5,000 per year—or $25,000. But if you take the $100,000, at 5 percent over 5 years compounded, it is $128,335. As you can see, the compounded interest had outperformed simple interest. The money put away in a bank with compound interest is always going to do better than the money just sitting in home equity. Furthermore, with an interest-only mortgage, the investor can deduct the full payment on his/her taxes.
For young entrepreneurs whose future income may grow, interest-only mortgages allow them to buy a more expensive home now. For business executives or professionals who receive bonuses, interest-only mortgages make special sense. Borrowers make lower payments, which helps them control expenses, and then periodically apply a bonus or commission toward the mortgage principal. In most cases, they get an additional, immediate benefit of a lower interest-only payment the next month.
For families with credit-card bills, interest-only mortgages can also help. If the amount that would go toward principal on a 7% mortgage is applied instead to credit-card debt that carries 18% or higher interest, those families will come out ahead.
Interest-only mortgages will especially help the real estate investor who wants to invest in real estate because it frees up usable cash that he/she would not have had otherwise.
Suddenly, this kind of mortgage is highly popular. Almost 95% of our business involves mortgages with interest-only components.
In 2001, just 16% of all home sales in the nation were financed by interest-only mortgages. But that number jumped to 31% in the past year. In South Florida, 31.2% of home sales in the Fort Lauderdale metro area—more than double the rate of the year before—and 37.6% of home sales in the West Palm Beach/Boca Raton area were financed by these kinds of mortgages.
Interest-only mortgages are still considered unconventional and continue to only make up a small portion of the overall mortgage market; but they are becoming increasingly popular in areas where the prices of homes are high, such as California, Washington, D.C., and Chicago.
The reason for the popularity of this kind of mortgage is remarkably uncomplicated: there is simply no advantage—ever—in a real estate investor making a principal payment on a mortgage.
By committing to the interest-only mortgage, the borrower will make more money by taking the amount that would have been used to pay down the loan principal and investing it.
The interest-only vehicle benefits those individuals who understand the time-use of money and wish to keep their money working for them. This kind of mortgage is an excellent vehicle for anyone who wants to utilize a mortgage for the purpose of wealth accumulation. The greatest beneficiaries of interest-only loans are going to be those with unusual income cycles. Those who expect to be earning more money a few years into their mortgage will also benefit.
And, finally those who want to invest the money that was saved by not paying the principal in some kind of investment other than home equity. Typically, these latter people are our new real estate pros.
STRATEGY # 18:
IF YOU PLAN TO LIVE IN YOUR HOME FOR ONLY A BRIEF AMOUNT OF TIME OR LONGER, CHOOSE AN INTEREST-ONLY MORTGAGE.
Interest-only mortgages are for people who plan to live in their homes for a short period of time. However, most important, these mortgages are for people who can afford the entire monthly mortgage payment. That is crucial. Otherwise, the whole effort to divert a portion of the monthly payment into investment vehicles will not work.
The interest-only program is not designed for investors who cannot make a full principal and interest payment, but for people who want to keep more of their earning dollars in their pocket or in another investment, thereby earning compound interest on their money.
That is why we call interest-only mortgages a cash management tool.
Historically, interest-only mortgages were popular prior to the Great Depression in the United States, in the 1920s and early 1930s. They were sold almost exclusively to wealthy people who wanted to free up funds for other investments.
The interest-only mortgages of the 1920s were interest-only for the entire life of the loan, typically five to ten years. What this meant was that the loan balance was the same at maturity as at the onset of the loan. Borrowers still in their homes when the loan matured would refinance.
Nothing bad came of this system of mortgage payments as long as the homes retained their value. But the real estate market did nosedive during the Depression, pushing many interest-only loans into a state of foreclosure. Viewing interest-only mortgages as stigmatized, lenders quickly switched over to fully amortizing loans, the standard mortgage loan since then.
More recently, mortgage specialists have tried to bring this highly sophisticated mortgage product to the middle market. It is considered highly sophisticated for this reason: interest-only mortgages permit borrowers to pay initially a lower monthly payment. Since, however, they are not obligated to pay against the principal, the build-up of equity is delayed. Because of this delay in building equity, these mortgages are not for everyone. Not everyone is willing to forego building up equity in a home by paying down principal.
Interest-only mortgages made a comeback once such large wholesale lenders as Fannie Mae started to offer the program. Fannie Mae started to purchase interest-only mortgages in 2001. That year, the government-sponsored enterprise bought $1.2 billion in interest-only vehicles on the secondary market. It called the mortgages ''Interest First'' vehicles. To qualify, the product had to be a fixed-rate interest-only mortgage with the borrower paying only the interest, tax, and insurance each month for the first 15 years of the loan. In the 16th year, the payment would grow to fully amortize the loan over the remaining 15 years of the mortgage term.
The new kinds of interest-only mortgages differ from the earlier ones of the 1920s in two distinct ways.
First, they are not interest-only for the entire term of the mortgage—only for the first five or, more typically, ten years. With the end of the five- or ten-year period, the monthly mortgage payment is hiked to the fully amortized level. In other words, once past the fixed period, these loans adjust to the fully indexed rate of the index plus the margin; the loans can adjust monthly. The mortgage essentially converts to a standard, amortizing mortgage either on an adjustable- or a fixed-rate basis.
For this reason, the more recent versions of interest-only loans seemed less risky than their counterparts from the 1920s. In fact, they are not. They are considered more risky. And here's why:
There is risk in any investment vehicle. Many people are under the misguided impression that real estate values will continue to appreciate indefinitely and consistently year in and year out. Yet real estate values are like any commodity that runs through cycles of ups and downs. Some of this has happened of late in our own real estate market in southern Florida, where people are paying X amount of dollars on a property but are unable to sell the property for more than they paid for it. It's becoming more of a buyers' market for particular product types: condominium units, single-family homes, and homes in certain price ranges or certain locations.
If you keep equity in a property there is risk, because the equity can decline if the market declines. However, if you refinance the property and take the cash out of that property, you do not come under pressure to return any of the borrowed money. As long as you make the monthly mortgage payment, the bank will not say, ''Your property is worth less, so you have to give back some of the money.'' If a stock declines in value, however, and you have outstanding loans on that stock, you would have to pay back the money (this is known as a ''margin call''.)
It turns out that limiting the interest-only period to ten years has little significance because a relatively small number of borrowers in current times keep their mortgage for that amount of time. Most are going to refinance or sell their homes while they are still in the interest-only period.
At the end of the interest-only period, the borrower can go back and refinance the mortgage, and take the five-year term all over again and possibly take some cash out of the equity.
The principal balance does not go down, but the borrower's payments remain under control. He or she is still making a full interest payment so that is taken care of.
In the 1920s version of interest-only mortgages there was no strategy to establish a mortgage savings account (known as a sinking fund). That's why the amortized mortgage was invented: so that the principal would be paid down over time. With today's new mortgages, however, the interest rates are capped; therefore you can manage the risk better and can establish your own mortgage savings account. This gives you the choice of making those mortgage payments, applying the amount to your outstanding principle; or using it to build added wealth.
Make no mistake about it: the risk attached to ARMs is high because borrowers have exposed themselves to rising mortgage rates when market rates increase. By adding an interest-only component, the borrower only adds to the risk because when the ARM rates get adjusted at some point in the future, the new monthly mortgage payment is figured—using the original loan amount, in contrast with the smaller amount that is the balance on a fully amortizing ARM.
One can use by way of example an ARM with an interest-only payment option lasting ten years with an initial rate of 4% that resets twice a year. Worst-case scenario: the rate grows by 2% every six months, reaching a maximum of 10% by month 19.
The interest-only payment in that nineteenth month would be 150% higher than the initial payment. The fully amortizing payment, by comparison, would be ''only'' 82% higher.
Significantly, it is the joining of the interest-only product to adjustable-rate mortgages that have made interest-only mortgages so popular today.
Once interest-only loans were linked to ARMs, it opened the door to a whole variety of merchandising promotions that, quite frankly, were misdirected. In particular, they were promoted as new kinds of mortgages, featuring lower rates than standard fixed rate mortgages.
The truth was that the rates on interest-only loans were lower because the loans that were being touted were ARMs, not because they contained the interest-only option. It is only fair to say that, because the interest-only option increases the risk of default, the interest-only option added to any given type of mortgage increases its rate.
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