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Interest-only loan can pay off for owner
Question of the Day
Tales of rising foreclosure rates and financial ruin have been linked in the minds of many consumers with interest-only mortgage loans, a borrowing product that became popular in the Washington area just as home values skyrocketed and the buying frenzy for homes began.
Now that the market has cooled and buyers have the time to take a more cautious approach to loans, some are frightened that an interest-only loan will lead to their own financial crisis in years to come.
In spite of that fear, local lenders report that a significant number of borrowers continue to opt for interest-only mortgages.
“The term ‘interest-only loan’ became a bad word in 2006 and 2007, but that’s mostly because people don’t understand what this type of loan is,” says Joel Epstein, vice president of Charter Funding in Rockville.
“Three or four years ago, an interest-only loan typically was a short-term, adjustable rate product,” he says. “Now, interest-only loans are usually 30-year, fixed-rate loans, which are interest-only loans for the first 10 years, then automatically turn into a 20-year amortizing loan at the same fixed rate.”
An amortizing loan means that the monthly payments will reduce the principal of the loan in addition to paying the interest.
Mr. Epstein says “everyone is doing 30-year, interest-only loans,” yet other lenders say some consumers are reluctant to use this loan product.
“People are still doing them, but fewer than before,” says Holly Davis, vice president and branch manager of the Tysons Corner branch of Market Street Mortgage. “The problem is that there is confusion between an interest-only loan and a negative amortization loan.”
Negative amortization occurs when the borrower makes low payments in the initial stages of the loan that result in additional principal added to the mortgage at a later date.
Jerry Darnell, a senior loan consultant with Washington Mutual in McLean, says the loans that were most dangerous for consumers, known as “2/28s” or “3/27s,” are rarely available anymore. Those loans often were also used for 100 percent financing, which meant that the consumers had no equity in the home they purchased.
“In the subprime market, consumers have been burned by those loans, which, after two or three years of low payments, adjusted to a much higher mortgage payment than they could make,” Mr. Darnell says.
“People hoped they could refinance, but they didn’t anticipate the drop in home values and the fact that you can only refinance up to 95 percent of the home value,” he says.
Interest-only loans today commonly have five, seven or 10 years of the interest-only period. Mr. Darnell says that 100 percent financing combined with interest-only loans are extremely rare today, in part due to stricter lender guidelines.
“The idea of these 2/28 loans was that it would help people with poor credit get into a home, which would help them build equity and fix their finances,” Mr. Epstein says. “The problem is that people did not clean up their act and improve their credit, and their homes depreciated in value.”
Educating borrowers so that they truly understand the consequences of their loan choice is crucial.
By David Keene
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