Friday, July 13, 2007

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.

Phil Drew, branch manager of the McLean office of Carteret Mortgage, says, “The key thing is that each borrower needs to understand what happens at the end of the interest-only time.”

Mr. Drew prefers the fixed-rate, 30-year loan with a 10-year interest-only period.

“Ten years is long enough to solve the reason why they went with the interest-only loan in the first place,” Mr. Drew says. “Either the home will have appreciated enough or the borrowers will have increased their pay enough to make the larger payments or they will have reduced their debt or finished putting a child through college by the end of the first 10 years of homeownership.”

Mr. Epstein says cost-of-living increases over a 10-year period can be enough to allow borrowers to afford the higher monthly payments. He also says that, over time, most homes average an increase in value of about 2 percent annually.

“The only downside of an interest-only loan is that at the end of 10 years, the payments will be higher,” Mr. Epstein says. “I wouldn’t recommend it for someone on a fixed income or for someone who is trying to squeeze into a home they really can’t afford. But for people who are fiscally responsible, this is a good loan.”

The monthly payments for both adjustable-rate and fixed-rate interest-only loans will be estimated on the truth-in-lending documents provided by the lender, including the initial loan repayment period and the secondary period when both principal and interest are being paid.

The adjustable-rate payments are more difficult to estimate because the interest rate will depend on the interest rate at the end of the initial loan period.

“It’s vitally important that the mortgage originator go into the worst-case scenario with the borrowers to make sure they are comfortable with the highest potential monthly payment they will have to make,” Mr. Drew says. “Thinking 10 years ahead is reasonable, and you can get most people to focus on that time frame.”

Mr. Darnell says that consumers need to think ahead when they purchase a home to estimate how long they will stay in the property, since this may influence the choice of a loan program.

“Homeowners build equity very slowly in the first three to five years of a 30-year loan, so if you think you are staying in the home long-term, it makes a lot of sense to do an interest-only 30-year loan,” says Mr. Darnell.

Mr. Drew and other lenders recommend that consumers pay some of the mortgage principal during the interest-only period, either by adding a little to each payment, making one extra payment each year or by using a tax refund toward the mortgage principal.

“Paying toward the principal means that there is less of a debt to amortize, so there can be virtually no payment shock when the interest-only period ends,” Mr. Drew says.

Mrs. Davis explains why paying additional principal can help consumers.

“Interest-only mortgages act more like a credit card than like a car loan,” Mrs. Davis says. “If you pay extra money toward the principal, it will actually reduce your monthly payments when you get into the second period of the loan. If you paid extra on your car loan, the payments would remain the same; it would just take you a shorter time to finish paying off the loan.”

Mrs. Davis says that some borrowers opt to pay the full amount of principal and interest each month for their loan, even if they have an interest-only loan.

“The flexibility of this loan is that, if you have a car break down or want to take a vacation one month, you can opt to pay just the interest that month,” says Mrs. Davis.

Mr. Epstein recommends that consumers take the difference between the interest-only mortgage payments and the monthly payments including principal and put that amount of money in their savings account each month to prepare them for the future increase in payments.

Mrs. Davis says that interest-only loans are rarely used today as “creative financing” to get people into a home they cannot afford, which was sometimes the case in the past when lenders anticipated a continued rise in home values to offset any concern about whether the consumers could afford the home in future years.

“Some lender guidelines require a borrower to qualify for a home with a fully amortized loan even if they opt for an interest-only loan,” Mrs. Davis says.

As long as consumers understand the interest-only loan and are prepared for the increase in monthly payments at the end of the first period of the loan, this type of loan product can provide valuable flexibility for borrowers.

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