The Concerns Over Interest Only Mortgages

Though interest-only mortgages have become the mortgage vehicle of choice, it seems prudent to go over some of the potential concerns. We want you to go into these mortgages with knowledge and understanding.

Some have worried that these mortgages encourage people to take the lower payments so that they can qualify for larger mortgages, enabling them to purchase more expensive property that in reality they may not be able to afford.

Others have expressed concern that these interest-only mortgages do not permit borrowers to build equity; and as a consequence, should real estate prices drop, borrowers could wind up obligated to pay more than their homes are worth in later years.

Another concern has to do with the prospect that the index used to which the interest-only mortgage is attached could become volatile. In that case, monthly mortgage payments could begin to fluctuate more rapidly than other instruments, which would look more stable by comparison.

If interest-only mortgages come with subprime rates (the rate that a borrower with credit problems qualifies for), the margins might be higher. So that if the index moves only a bit, the size of the monthly mortgage payment could grow larger than planned for.

Needless to say, all of the above underline why it is so important to turn to a mortgage professional who can explain all of these various possibilities. The real estate investor must have some sense of how the index moves; of what constitutes the fully indexed rate; and, it goes without saying, of the length of the terms for the interest-only payment period.

It is also wise for investors to understand the degree to which they are operating in the expectation that (a) their income will increase during the time of the interest-only loan and (b) their house or houses will appreciate in value. What if these two things do not occur?

The unfortunate example is given of the person who has purchased a home for $100,000 and paid an interest-only mortgage for ten years. He has a mortgage of $80,000.

The ten years pass, the person still owes $80,000 on the house. But now that person wants to sell the house for $100,000 because he had 20% equity in the house. If property prices appreciated at only 3% a year, the property would be worth $134,935. But what happens if there is zero appreciation, or worst of all, if there is depreciation? That would leave the borrower of an interest-only mortgage owing more than the house is worth. And on occasion, this does happen.

Most lenders, however, do not concern themselves with interest-only mortgages going ''under water.'' Home prices historically have appreciated 6% a year and that large appreciation makes such risk seem low.

Most lenders require borrowers to qualify at the fully indexed rate, including amortization, demonstrating to the lender that the borrower has the financial wherewithal to make a full payment, The banks want to make sure that, if interest rates move, the person holding the interest-only mortgage will still be able to make all monthly payments.

The key here is that interest-only mortgages work if the borrower is disciplined and understands both the risks and benefits associated with interest-only mortgages. We know why these mortgages are attractive—they offer a much smaller monthly mortgage payment. But they carry a risk, and we want everyone to factor in that risk before deciding on the kind of mortgage product to take. The whole premise of an interest-only mortgage is that the borrower is not going to use the money saved to go off on a winter vacation or to purchase a better car.

One young man called into our television program wanting advice on how to allocate the funds he had. At the time he called us, he was in graduate school studying to become an engineer. He was making $65,000 a year. He was renting his home and he wanted to buy his own place. He planned to graduate from grad school in two years. He assumed that his income would go up 25% by then.

His questions to us were practical: Should he buy a home now? Or should he put the money that he was able to save in a 401K, because the stock market might outperform the real estate market over the next decade? He had been putting $800 a month into a401K.

We told him that if he could get into the right mortgage pro-gram—and there were many of them, some affording the lowest possible monthly payments—he should buy a home today, using the most amount of leverage that he could, and that he should continue to invest in his 401K.

By blending these types of disciplines, we told him, he could have his cake and eat it too. He was paying rent, but the rent was going to the benefit of someone else, someone who was paying down a mortgage or putting that cash flow into his or her own pocket.

He had no reason to wait, we said, and we asked what he thought he would be able to come up with as a down payment. ''Thirty thousand dollars,'' he said.

We made our calculations on the basis of his purchasing a property worth $300,000. He could obtain a mortgage on a loan to value of 80%, getting a mortgage of $240,000. Using one of our New Smart Loans™ at a pay rate of 1%, he would only have to pay $771 a month. He could then get a line of credit from his bank on the $30,000 equity, which would cost him $180 a month.

So, adding $771 and $180, he would be paying $951 per month as his mortgage. Since he is in a 30% tax bracket, $285 of that $951 amount represents tax savings.

Let's say the taxes on his new property come to $5,000, or $400 a month. He would have to pay $951 plus $400, or $1,351 a month, which represents $947 net after tax savings. He is now paying $800 a month in rent. His net dollars are $949; thus he is paying $147 more, but he would own his own real estate.

People always ask how they can get the money earlier than ten or fifteen years in these mortgage savings accounts. The happy answer is that they can access their account after twelve months and take out 10% of what they invested on a regular basis. After five years they have all sorts of options, one of which is to take out all the money accumulated over that period of time.

People ask us about the interest-only mortgages and what they can do to improve their net worth. These people are put in touch with financial planners who explain how they can accumulate wealth using an interest-only mortgage.

Within that mortgage savings account there are various investment strategies to pursue. Some of the investment vehicles that generate money for these accounts come guaranteed and some do not. For all the money that someone is investing, in addition to those guarantees, we need to ensure that money is growing at the proper rate.

It is fascinating how much misinformation is disseminated by the media and also by people who are supposed to know, namely some of the people in the Federal Reserve Bank.

They have concerns about people taking money or buying property using interest-only mortgages and then finding that at the end of a five-year period these interest rates are going to be untenable, leading people to lose their properties. That shows a true lack of understanding of the way many of these mortgages work. But it also shows there is no forward thinking; there is no thinking about how borrowers can benefit from interest-only programs.

Look at the numbers at the end of five, ten, and fifteen years. The concepts are fine but it's the numbers that truly show the benefits of these programs.

Many people say that if they're able to go into a 15-year mortgage, after which their house will be paid off, they will truly be happy. What they don't understand is that the 15-year mortgage is better designed for the benefit of the bank because the bank is taking that principal payment and lending it to someone else.

There's a better way to use that money for your—and not the bank's—benefit. One option is to put the money into a mortgage savings account. This is where you put the money that didn't go into the mortgage payment into your family's bank account.

Within 15 years you will have enough equity and money in a mortgage savings account to pay off the loan. But we advise against paying it off at all. There's just no reason to.

This kind of investing requires discipline: you have to have a plan, and you have to follow through with that plan. There are some things you can build into the plan that make it easier to be disciplined. For example, you can automatically transfer money into a mortgage savings account. In this way, the borrower does not have to perform the more burdensome chore of writing a check every month.

Take the example of an investor with a property that is worth $400,000. Let us look at different mortgage programs for a mortgage of $320,000. Among these programs is one with a minimum payment and a 1% pay rate; another, an interest-only mortgage, with an interest rate of 6.17%. Then there is a 40-year amortization mortgage and a 15-year one.

The difference in payment is really what is so dramatic.

The actual interest rate is about 5.5% and the Annual Percentage Rate (APR) is about 5.86%. The APR is an interest rate that is commonly used to compare loan programs from different lenders. The Federal Truth in Lending Act requires mortgage companies to disclose the APR, which measures the true cost of a loan, when they advertise a rate.

But the pay rate on the minimum-interest mortgage is only 1%, which on $320,000 is $809 a month.

With the 15-year mortgage, the monthly payment comes to $2,600 a month. What people like about this kind of mortgage is that after 15 years, making a $2,600 monthly payment, they will have paid off their mortgage. True, they will have paid off the mortgage, but what do they have left in terms of liquid assets (usable cash)? Nothing.

If you keep that $320,000 instead of giving it back to the bank, you will have usable cash. If you do not pay off the mortgage through a fixed rate program, you will accumulate wealth much faster (oh, how money grows and grows when it's earning compound interest!)—and you will still have the property. In addition, of course, you will have enough cash in the mortgage savings account to pay off that note at any time.

But what do the banks do? They put clients in a mortgage that really benefits somebody else because they really don't believe that people have enough intelligence, enough discipline, in order to save their own money and put it into a separate account.

At the end of 15 years, if the person wants to get that money back, he or she has to go back to the bank and refinance the property.

To go back to the numbers: The minimum payment of $809 can increase slightly, by 7.5% of the $809 over the first five years.

That comes to $60. If we had $1,800 of savings between the $2,600 and the $809, you actually have $1,890 because every time you make an investment into a mortgage savings account, the payments get increased automatically by 5%; that's free money—every single time you make a deposit. At the end of five years, you will have $122,400 ($108,400 that you have deposited, and $14,000 in interest) in this account.

Calculations will show that this $400,000 property, assuming a 7% yearly appreciation, at the end of five years will be worth $561,000.

Now in the case of the $320,000 mortgage, it actually increased because you are deferring interest; so it went from $320,000 to $347,000. This is the fear that everyone talks about. They say that at the end of that period the mortgage is going to increase, Let's say yes it does: now it's $347,000.

You have $214,000 of equity as opposed to the roughly $240,000 you would have had if you were paying down the principal.

If you use this interest-only program and you make no principal payments but deposit the difference in the mortgage savings account, at the end of 14.8 years, you would have sufficient money to pay off your mortgage—and you would wind up with an additional $203,000 in cash in the bank. The earlier you can start all this, the better off you are going to be, so be sure to take advantage of the compounding of your money in a mortgage savings account without delay.

There's a need for better education about these mortgages and about what to do with the money. The conventional thinking is that once you have this money, you're going to spend it and waste it.

Is there a risk of that? Absolutely.

But it doesn't mean that people shouldn't be given that opportunity to take advantage of these programs. It's not the responsibility of the government—of Big Brother—to tell you how to manage your money.

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Amortization Loans

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