Interest-only mortgage ahead: Proceed with caution

They’re popular but they aren’t for everyone.

The Federal Deposit Insurance Corp. says Colorado ranks third in the nation for its share of interest-only mortgage loans on the books. Nearly 44 percent of the state’s new purchase loans in the first half of 2005 were interest-only, or double the national average, according to the FDIC.

The interest-only approach is plenty popular locally as well. The Fort Collins metropolitan area was one of four in Colorado ranked in the top 25 in the nation for areas where interest-only loans exceed 40 percent of all purchase loans.

These loans have grown in popularity over the last three to five years for a variety of reasons, loan officers say.

Despite the interest-only loan’s popularity, mortgage and banking experts say that borrowers should proceed with caution when considering these loans.

“They’re not something that we encourage people to do, frankly,´ said Chuck Mabry, CEO of Norlarco Credit Union. Mabry said borrowers gamble that the value of their property will increase. If it doesn’t they don’t accumulate equity.

The market itself may be part of the impetus behind rising numbers of interest-only loans, Mabry said.

“The market in Colorado has become pretty strong. Values are pretty high. Therefore, in order for people to find a home they can afford to buy, they’re having to go to interest-only loans in order to be to make the payments on it,” he explained.

Various advantages

Because the payments are typically lower at the front end of an interest-only loan, buyers can qualify more easily and sometimes for a more expensive house.

“A lot of investors like it because it keeps their cash flow down,´ said Sandy Cook, loan officer with America’s Mortgage.

And for some borrowers the flexibility of a lower payment combined with the option of sometimes paying down principal is a better lifestyle fit.

Doug Klein, owner/partner at Front Range Mortgage Professionals, said an interest-only mortgage can work well for self-employed borrowers and those who get paid on commission.

“These people may need a little bit of a break on a month-to-month basis,” he said. “Then, all of sudden once a quarter or two or three times a year when they get a large (income check) they can make payments toward the principal.”

The savvy and disciplined borrower may even end up ahead, Klein said. “You may end up further down the road with your principal reduction than if you just stuck to the amortization schedule of a regular loan.”

A variation on that theme is sometimes suggested as a benefit behind interest-only loans. Individuals may invest the principal amount they are not paying in monthly payments into something that provides a higher rate of return than the interest rate on their mortgage.

However, investment experts frequently point out that with a flailing stock market and still-low short-term rates, paying off a mortgage loan is probably the better investment.

Klein also pointed to mortgage loan demographics to explain the popularity of interest-only loans.

“Basic knowledge will tell you that most home loans aren’t in place for longer than five years. It’s a national average,” Klein said. “So, if you’ve put 50 percent down on your home and you’ve got assets in the market, in real estate, and you’re only going to be in the house for three years and are not concerned about principal reduction, an interest-only loan makes sense.”

Specific risks

Simply put, payments on an interest-only mortgage consist solely of interest for an initial, specified period, typically five to 10 years. These interest-only set-ups can take place with conventional loans, where the interest remains unchanged for the life of the loan, or adjustable rate mortgages, where the interest rate fluctuates.

Risk accompanies any loan. Some of the risk specific to interest-only loans include:

n Monthly payments rise. While the initial payment of interest only is lower than a conventional mortgage payment – which includes interest and principal – after the interest-only period expires, payments will be higher.

n Add additional potential costs if the loan has an adjustable rate. Many predict interest rates will rise in the future. A higher interest rate at the end of the interest-only period could mean an even higher monthly payment.

n Interest-only loans cost more. The interest rates on interest-only loans are typically .25 to .5 percent higher.

n Equity may be compromised. If housing prices fall during the interest-only period and the borrower needs to sell the house, proceeds from the sale may not cover the balance of the loan.

With interest-only mortgages seen as a good bet where real estate values are rising, Colorado interest-only borrowers could be riding for a fall. In the third quarter of 2005, home prices in Colorado were appreciating at 5.6 percent compared to 12 percent appreciation nationwide. But Northern Colorado lagged even further behind the rest of the state. Appreciation in the Greeley metro area was just 2.2 percent, and Fort Collins-Loveland was 4 percent.

Colorado ranked 45th in the nation for real estate appreciation.

Interest-only loans can be risky, Cook said. “Borrowers have to be knowledgeable about that. But they have definitely gotten a lot of people into housing that normally wouldn’t.”

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