- The Washington Times - Wednesday, June 8, 2005

I’m compelled to revisit interest-only loans, something I’ve written about a few times over the past year. It seems that the mainstream media is only now beginning to talk about interest-only loans. Suddenly, I’m seeing the subject featured in newspapers and on the Internet as if it were something brand new.

I don’t necessarily disagree with everything that is being said. I’m in this business every day, talking to buyers facing skyrocketing home prices and homeowners salivating over low interest rates and low payments.

Let me give you my view.

Interest-only loans allow the monthly payment to be equal to only the interest charged for that month. The principal balance does not change. In contrast, a loan that carries a 30-year amortization requires a monthly payment that covers the interest charged, plus enough of the principal balance that will pay the loan to zero in 30 years.

The difference in payment is startling. An interest-only payment is lower by about 20 percent, regardless of how much you borrow. For example, a $350,000 loan with a 30-year amortization at 5.75 percent will cost $2,042 per month. An interest-only payment would only cost $1,677.

Looking at it the other way, interest-only loans allow a buyer to afford 20 percent more house. If $2,042 is your maximum comfort level, an interest-only loan would allow you to borrow $426,000 at 5.75 percent, as opposed to the $350,000 amount on an amortized loan.

Now let’s get to the question as to whether interest-only loans are “dangerous.” As with anything else, it depends.

Remember that these loans give you merely the option to pay just interest. You are always free to plow money into the principal and pay it down.

Skeptics charge that the frenetic housing boom cannot be sustained. I wholeheartedly agree. In fact, I’m so pessimistic that I think certain areas in Washington will face home-price depreciation. But does that mean interest-only loans are dangerous? It depends.

Interest-only loans, unfortunately, have become a necessary product for home buyers in this area. Home prices have skyrocketed to such levels that folks who have relocated for whatever reason are stung by sticker shock. Simply put, housing is no longer affordable in this area.

But the difference between borrowing $426,000 and $350,000 may offer a family an opportunity to buy a nice house, thanks to an interest-only mortgage.

Let me say that I don’t in any way solely promote interest-only loans, but they are a viable option for those folks who are used to paying $200,000 for a four-bedroom Colonial in Ohio. Suddenly, they’re transferred here and the same money buys them a two-bedroom condo.

Interest-only loans have gained popularity because income and wages have not risen at the same pace as home prices.

The way I see it, there are four basic dangers to look out for if you’re considering an interest-only loan.

First, know the length of the interest-only term. If you take out a 5/1 ARM, for example, you will probably be allowed to pay only interest for the first five years. After that, you must pay off the loan over a 25-year period. Plus, your interest rate could be higher. The result: Severe payment shock.

Second, contrary to what I’ve read, make sure your plan is to hold your home for a reasonable period of time — at least five years. Some say an interest-only loan is appropriate for folks who have a short holding period because very little principal is curtailed in the early stages of an amortized loan, it doesn’t matter. While that may be true, it’s irrelevant. Real estate values are cyclical.

An interest-only loan can be dangerous if the buyer is solely relying on unreasonable appreciation expectations over the short term. Markets will turn. We just don’t know when.

Third, make sure you are able to pay at least 10 percent down. If the market turns and your property value drops when you need to sell, you won’t be left “upside down,” meaning your mortgage balance is greater than your property’s market value.

Last, if possible, do something smart with the cash savings. Invest in your IRA or open a college fund.

An amortized loan is nothing but a forced savings plan. You are required to pay down your loan. An interest-only loan gives you the freedom to do what you want with the difference. If the loan carries a low, tax-deductible rate, it’s certainly reasonable to surmise that taking out a interest-only loan and investing the difference wisely will earn a better return than the cost of the mortgage.

The bottom line is this: Interest-only loans give the American consumer more choice. But choices go hand-in-hand with responsibility. Choose wisely.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).


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