I continue to be dumbfounded by the claims about interest-only loans reported
to me by mortgage shoppers. Whether the claims originate with loan officers or,
as one defensive loan officer suggested to me, they arise in the over-active imagination
of shoppers who still believe in the tooth fairy, I can’t say for sure. Probably
it is some combination of the two. All I know for sure is that misperceptions
abound, and I keep running into more of them.
Misperception 1: Interest-only loans are a type of mortgage. They are
not. Interest-only is an option that can be attached to any type of mortgage.
For example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly
payment of $599.56. This is the fully amortizing payment -- the payment
which, if maintained over the full term of the loan, will just pay it off.
In month 1, that payment divides into $500 of interest and $99.56 of principal.
In month 2, the payment remains at $599.56 but the breakdown is $499.50 and
$100.06. Each month, the interest portion declines and the principal portion
rises. After 5 years the balance is $93,054. That is how mortgages amortize.
Now lets attach an interest-only option to this mortgage, available, say, for
the first 5 years. That means that the borrower need pay only $500 a month during
the first 5 years. There is no payment to principal.
If the borrower exercises the option, therefore, the balance after 5 years
is $100,000. There is no amortization. Beginning year 6, the borrower must begin
paying $644.31. That is the fully amortizing payment for a 6% loan of $100,000
for 25 years.
Misperception 2: It is less costly to amortize an interest-only loan.
This is patently ridiculous, but some variant of it keeps popping up in my mail.
Suppose a borrower takes the mortgage described above with the interest-only
option, but decides to pay $599.56. He doesn’t exercise the option but makes
the fully amortizing payment instead. Then the loan will amortize just as it
would have if the interest-only option had not been attached. After 5 years,
the balance will be $93,054. If you make the same payment on the same mortgage,
you end up in the same place.
If the borrower pays $700 a month instead of $599.56 on the same mortgage,
the balance after 5 years will be $86,046. Whether the mortgage did nor did
not have an interest-only option will matter not a whit.
Misperception 3. An interest-only loan carries a lower interest rate.
Lenders might charge a higher rate for a loan with an interest-only option,
because the risk of default is a little higher on loans that amortize more slowly.
But a lower rate would be irrational.
The notion that interest-only loans have lower rates arises from comparisons
of apples versus oranges. Adjustable rate mortgages (ARMs) with an interest-only
option have lower rates than fixed-rate mortgages (FRMs) without an option.
But an ARM with the option does not have a lower rate than the identical ARM
without it.
Since the interest-only option is available on both FRMs and ARMs, it is pointless
to be sucked into an ARM because of that feature. First choose whether or not
you want an ARM or an FRM. This decision should be based on how long you intend
to have the mortgage, and on your willingness to accept the risk of a future
increase in the interest rate in order to have a lower rate in the short-term.
If you opt for an ARM, then select the other ARM features you want, including
an interest-only option.
Misperception 4. On an ARM with an interest-only option, the quoted interest
rate is fixed for the interest-only period. It is not. This is the most
dangerous misperception of all because it can induce borrowers to take ARMs
that don’t meet their needs.
The interest-only period is the period during which you are allowed to pay
interest only. The period for which the initial rate holds is a different matter
altogether. On an ARM with a very low rate, the interest-only period is always
longer than the initial rate period.
A common ARM today has an interest-only option for 10 years, but the initial
rate holds only for 6 months. On a $100,000 loan with an initial rate of 4%,
the interest-only payment is $333. If the rate after 6 months goes to 6%, the
interest-only payment would jump to $500. Borrowers who thought they were safe
for 10 years would get a rude awakening.
November 20, 2003 Postscript
Misperception 5. Interest-only loans are appropriate if you don't expect
to be in the house very long. I don't know where this idea comes from, but
it makes no sense. If you don't expect to have the mortgage very long it makes
sense to select an ARM because the rate will be lower, and it makes sense to
avoid paying points because there won't be much time to recover your investment
through a lower rate. But the decision to take an interest-only should not be
affected by your time horizon.
February 10, 2004 Postscript
Misperception 6. Interest-only loans don't require PMI. Some loan officers
are shameless in the stories they tell borrowers, and this is another one. Of
course, some interest-only loans don't require PMI because the loan is too large
relative to the borrower's equity, or the deal is otherwise sub-prime. In these
cases, the borrower is paying the insurance in the interest rate.
If there is a loan that requires PMI but does not require it if the loan has
an interest-only option attached, it would be because the insurer doesn't want
the greater risk entailed by the PMI. In such case, the implicit insurance premium
in the rate is bound to be larger than the PMI premium.
April 8,2003
