Imagine having a home loan where you only had to pay the interest each month, while ignoring the principal. Sounds great, right? It would certainly reduce the size of your monthly payments, freeing up cash for other purposes.
There is such a loan. It’s called the interest-only mortgage loan, and it appears to have made a comeback over the last couple of years. In 2015, a number of lenders are offering this type of product.
But if they sound too good to be true, that’s because they often are. Here’s what borrowers need to know about these high-risk mortgage products.
Interest-Only Home Loans Defined
As the name implies, an interest-only home loan is one where the borrower pays only interest for a certain period of time. During this time, none of the monthly payments are applied to the principal. Therefore the principal amount borrowed (and due) remains the same.
The interest-only payment period does not last forever. The borrower will have to pay off the full principal at some point. In most cases, the interest-only period last for 5 to 10 years, but there are other product variations as well.
Home buyers use these loans to minimize their monthly payments during the first few years of the repayment term. These products are commonly used by borrowers who expect their income to grow over the coming years. For instance, a recent college graduate who lands a good job with high income potential might use an interest-only home loan to reduce the monthly payment during the first few years, until his or her income increases.
But this is where the interest-only mortgage can come back to haunt you. If the expected income growth does not occur, the borrower could be stuck with an unaffordable home loan. That’s because the monthly payments could eventually increase, when the interest-only period expires.
Making a Comeback in 2015
Interest-only mortgage loans were all the rage during the housing boom years of the late 1990s and early 2000s. They faded from use when the housing market collapsed, because they’re essentially a riskier type of mortgage. And lenders were doing everything to reduce risk in those days.
Now, in 2015, interest-only home loans seem to be making a comeback. More lenders are offering them these days, despite the bad reputation they earned during the housing collapse.
But the prevalence of these loans doesn’t change the fact that they are full of risk. Borrowers who fail to sell or refinance the home before the interest-only period expires could see a huge jump in their monthly payments.
Consumer Protection Agency Calls Them ‘Toxic’
The federal government actually warns borrowers away from interest-only home loans. This alone should raise some red flags in the minds of would-be borrowers. But despite such warnings, many borrowers embrace these products as a way to reduce their monthly payments.
It’s true, an interest-only mortgage can reduce your monthly payments. But that’s only because you’re ignoring the principal. You’re putting off the actual debt until a later date, which often causes problems down the road. At some point, the remaining loan balance will be amortized for a shorter period of time, thus increasing the size of the payments.
The Consumer Financial Protection Bureau (CFPB) has lumped interest-only products into its definition of “toxic loan features.” They’ve also excluded these products from their definition of a Qualified Mortgage (QM), a home loan model that is designed to reduce the amount of risk passed on to the borrower.
According to a 2013 press release that explained the new QM rules, CFPB officials stated: “The rule also protects borrowers from risky lending practices such as ‘no doc’ and ‘interest only’ features that contributed to many homeowners ending up in delinquency and foreclosure after the 2008 housing collapse.”
In a separate but related news release, CFPB said their new rules were designed to protect consumers from “irresponsible mortgage lending” and “toxic loan features,” such as an interest-only payment structure.
‘Payment Shock’ Associated with Interest-Only Mortgages
It begs the question: Why has the government worked so hard to shield consumers from these mortgage products? What makes them so “toxic” and “risky”? It has to do with the long-term behavior of the loan.
In the short term, interest-only loans almost seem to good to be true. You take out a mortgage to buy a house, and you basically blow off the principal debt for a while. You only pay the interest that is due each month, reducing the size of your monthly payment. This makes the loan more affordable and allows you to buy more house. But only in the short term.
Over the long term, it makes the loan more of a risk. That’s because you’ll eventually have to tackle the principal, and this could cause the size of your monthly payments to increase significantly.
Unlike a traditional fixed-rate mortgage loan, where the interest rate and monthly payments stay the same, an interest-only home loan can lead to higher monthly payments down the road. When the interest-only period expires, the untouched principal is factored in and there’s a shorter amortization period as well. So the borrower might have to repay the entire outstanding principal in a shorter period of time, resulting in much higher payments.
In some cases, the monthly payments rise beyond the borrower’s ability to repay, resulting in financial hardship or even foreclosure. This is referred to as “payment shock.”
Bottom line: Interest-only home loans aren’t always bad. In some cases, they can actually work out to the borrower’s advantage. The point is that they are much riskier than a traditional fixed-rate mortgage loan, where the borrower chips away at the principal from day one. You really have to know what you’re getting yourself into, when using one of these products. So buyer beware.