Interest-Only Loans….are they risky?
The Fed responded yesterday to the question concerning potential real estate bubbles breaking across the country. The past few years of record low interest rates coupled with very high appreciation, in many markets, have some analysts predicting an extreme downturn in residential housing prices as interest rates go up.
Additionally, some analysts have been predicting interest rates soaring into double digits by the end of the year. The proposed result: homeowners would find their properties are no longer valued at the price they paid and, since many purchased their homes with adjustable rate mortgages, interest-increased payments would become unaffordable.
Over the last few years, with rates dropping to record lows, interest-only loans became extremely popular. Many of my clients opted for an interest-only payment based on the assumption that rapid appreciation would create equity in the property. I have seen incredible appreciation in the area I live, with some properties doubling in value in less than ten years.
With an interest-only payment, borrowers are able to buy a much more expensive house and still manage the payments. While I don’t agree with many of the “doom and gloom” folks expecting interests rates to reach such levels borrowers are no longer able to purchase homes, I also don’t think the extreme appreciation many areas have experienced in recent years will continue.
Do I think real estate in these areas is going to depreciate? Probably not. Greenspan said yesterday that, historically, periods of depreciation in real estate values are actually very rare. So are interest-only loans a risk?
As with any other investment, the amount of risk depends on the individual. What may be very practical for one borrower could be very risky for another.
Example #1: An established commission sales person with a fluctuating income gets an interest-only loan in order to ensure in low-commission times they have least payment possible. Then, when commissions are collected the sales person pays a a lump sum directly to the principal. The sales person has figured out the amount of principal payment he/she would be making each month with a full payment loan. He/she pays that amount or more to the principal of the loan periodically. The sales person is still creating equity in the property by reducing the principal balance on the loan, but has lower payments each month. An interest-only loan in this scenario is low risk.
Example #2: The borrower chooses an interest-only loan so that he/she can buy a more expensive house. He/She has other revolving debt and little-to-no savings. The borrower is assuming equity will build in the property through appreciation, not by reducing the principal balance of his/her loan. The borrower gets transferred or loses a job after a year or so. In trying to sell the house, the borrower discovers that he/she can not sell the property for enough to cover the sales expense and payoff the loan. The borrower basically owes more than or, at best, equal to the property’s value. This is a high risk scenario.
Since no one can guarantee what future market conditions are going to be, the borrower must in all instances plan for “worse-case”. Examples of “worse-case” could be: lower than expected appreciation, interest rates adjust upward too quickly creating negative amortization, or the property has to be sold for unexpected reasons and there is no equity.
Anyone considering an interest-only loan program should discuss it with their broker and/or other financial advisors. The borrower needs to be confident that his/her reasons for chosing the interest-only program will outweigh the potential worse-case scenario. His/her financial planning should include making periodic payments to the principal balance of the loan to ensure he/she is building of equity in the property.