The new “Qualified Mortgage” Rule will be taking place in January 2014, which will result in the discontinuation of Interest-Only loans. There may be a small handful of portfolio lenders that will continue to offer interest-only loans, but for the most part, they will be a thing of the past. Since there is a small window of time for you to opt for an interest-only loan, I wanted to go over its features, advantages and disadvantages so that if you are in the market, here are some considerations.
An interest-only loan is exactly as it sounds: You pay only on interest owed; there is no principal reduction. They are not the right product for the majority of homeowners, but for the right person, they can be an excellent financing tool.
Since our credit crunch, lenders have put in place many rules that require a borrower to qualify at a fully-amortized, higher interest rate than what you lock in and what your interest-only payment will actually be. This helps assure that even though you are in a more risky loan program, once the payment does adjust, the lender has more confidence you will still be able to make that new payment. In addition, down payment and equity requirements are more stringent, to allow for a reduction in home prices.
Advantages to an Interest-Only loan:
Payment adjusts based on the new loan balance. If you do have an opportunity to pay down on principal, then your interest-only mortgage payment will adjust based on the new loan amount. So if you anticipate having an influx of cash and can make a large one-time principal reduction, this can be beneficial. As an example, let’s say your initial loan amount is $450,000 at an interest rate of 4.0%. Your interest-only payment will be $1500. If you are able to pay the loan down by $50,000 through some means, then your new payment will be based on the new loan balance of $400,000. Your new monthly payment would then be $1333.33. This is an advantage unique to interest-only loans, not to fully-amortized ones.
Monthly cash-flow savings. If you are a commissioned or self-employed borrower with fluctuating income, this can sometimes be helpful during those more-difficult months of income. For a seasoned or savvy investor, you can also determine the amount that would normally be applied towards principal and invest it elsewhere. For instance, let’s again use a loan amount of $450,000 and an interest rate at 4.0% as an example. Your interest-only monthly payment will be $1500. If this was a fully-amortized loan (principal & interest) at the same rate, then your monthly payment would be $2148.37. As an investor, if you are confident that you can earn a higher rate of return on the money being applied towards principal by investing that difference elsewhere, then you may benefit from this program.
Disadvantages to an Interest-Only loan:
Potential long-term risk. If you only make the interest-only payment (no payment towards principal) during the fixed term of the loan, then you will still owe the same amount after so many years. Any equity build-up would rely solely on the housing market and home appreciation. So if there’s a downturn and you need to sell your home, you will have built no equity and may have to sell your home at a loss.
If you do end up keeping the interest-only loan, then at some point depending on the program and your Note, you will be required to pay down on principal. The mortgage payment will be based on your Fixed Margin + Index, and amortized over the remaining life of the loan (30 years). Even if your new interest rate is less, the jump from paying just interest to paying principal + interest over a shorter term will result in a significant payment increase. If you are not prepared for a large increase, this can be detrimental to your finances.
Higher interest rate. Interest-only loan programs do carry a higher interest rate than fully-amortized loans because of the inherent risk. So in the long-term, even though your payment is less, you will end up paying more in interest over the life of the loan.
The time to get a competitive interest-only loan is coming to an end, and even though very few homeowners elect for this loan program after learning the hard lessons of our most recent housing bubble, it is always good to be as informed as possible.
