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Interest-Only Loans: Unnecessary Risk or the Path to the Future?

A recent issue that has surfaced in the past year is the discussion around interest-only loans. The major reasons for the sudden presence of this discussion are the numerous reports circulating about how much market share these products are commanding in the mortgage lending market. As a result of the typical economic data lags, many economists have begun talking about the potential effects these loans could have on consumers, the market, and the economy as a whole.

Interest-only loans first began being written in the 1920’s. After the depression in the 1930’s, many of the loans that were foreclosed on were interest-only loans (Kass, 2006). Now in the next century, non-traditional, interest-only loans have increased from 6% of all loans written nationally in 2002 to 31% of all loans written in just the first two months of 2005, according to Loan Performance of San Francisco, as reported in the 12th Federal Reserve monthly newsletter. The percentage of interest-only loans has jumped even higher in markets with particularly high priced real estate. For example, California had an increase in interest-only loans from 8% of all loans written in 2002 to 61% of all loans written in the first two months of 2005 (12th Fed Reserve, 2005). In the Washington D.C area, 54.3% of home purchasers were using interest-only loans (Downey, 2005). These percentages represent huge increases in what is termed as a non-traditional loan product. I will look at the pros and cons of why this is controversial in today’s real estate market and why the federal regulatory agencies and the mortgage industry are currently in debate.

Interest-only loans for the residential sector are mortgages that have a period of time, normally 5, 10, or 15 years, where the homeowner only needs to pay the interest on the loan and no principal. There are several different variations of this loan concept. Some interest-only mortgages have an adjustable interest rate for the entire life of the loan while others have a fixed rate for a certain period of time which then becomes an adjustable interest rate. In the past couple of years several banks have begun offering a 30 year, fixed rate, interest-only loan, which means the interest rate is set for the entire life of the mortgage but principal payments are not required until a specified time. U.S. Bancorp added this type of loan in September of 2005, and as a result, has seen this loan increase to 8% of all new residential mortgages issued. The fixed rate, interest-only mortgage has increased dramatically in popularity as interest rates have started to increase and borrowers are adjusting to this change (Simon, 2006).

There are many other types of loans that are related to or are the result of the interest-only loan, with several new loans stretching beyond the traditional 30 year mortgage, to 40, 45 or even 50 years. Provident Bank Mortgage, in Riverside, California began offering a 50 year loan as an option, mostly as a result of the increase in demand for interest-only loans. Richard Hegg, the wholesale production manager, in responding to the extremely competitive market for extending loan terms said, “In Japan, for example, they have 100-year-term mortgage loans. We are getting closer to becoming a global economy and we want to be the leader in this.” (Dymi, 2006) Another, somewhat related version of the interest-only loan is a negative amortization loan. This loan requires only part of the interest payment, with the rest of the interest charges being added to the principal amount.

What is causing the dramatic increase in the use of interest-only loans? The main reason for the increase is that interest-only loans traditionally were used by investors in fast-appreciating housing markets to capitalize on the increasing sale prices. As housing prices continued to increase, many families have started to use this as a way to purchase a home in the appreciating housing markets. (Mitchell, 2006) Another reason is the low personal savings rate we are facing in our economy. As stated in the Federal Reserve Bank of San Francisco in their monthly economic letter, “In September of 2005, the personal saving rate out of disposable income was negative for the fourth consecutive month” (FRBSF, Economic Letter, 2005). This means people have expenditures greater than their incomes. Because of the low personal savings rate people are trying to stretch their earnings as far as possible, leading to the attractiveness of interest-only loans where paying no principal can save hundreds of dollars per month.

Tax laws also make the interest deduction a vehicle for homeowners to use the equity in their homes to pay for other things such as cars, credit card bills, or other expenses. The interest deduction makes borrowing higher loan to value amounts beneficial to many families (Pender, 2006).

The positive and negative aspects of interest only loans are numerous on each side of the spectrum. The main positive attributes of an interest-only mortgage are the ability to use the principal payments in another manner and that this type of mortgage allows a homeowner to buy a home that they might not be able to currently afford with a traditional mortgage. The strategy of using the principal payments in another manner has a few different possibilities, as the homeowner could use the savings from not paying principal to invest in something that has a higher return than paying off the loan. When the loan begins full amortization the homeowner will be able to use the additional income earned from the money to aid in making the principal payments. Individuals with fluctuating income, such as someone on a commission based salary, can benefit from the flexibility to use the savings from a lower payment to pay for other necessary expenses during slower income periods. Many industry professionals note that the interest-only option is great for a young professional who may have a lower salary now but in five years will have a higher income. They can purchase the house now and meet the monthly payments now and in the future. As one borrower notes, “In the beginning stages, when you purchase a home, you have a lot of expenses, ‘the interest-only feature’ allows you some flexibility” (Simon, 2006). The Clearing House, a mortgage industry group, cites that borrowers benefit from an interest-only loan during the initial seven years of a mortgage when there is little or no principal paid on any mortgage (Neubert, 2006).

The interest-only option is very attractive in real-estate markets with escalating prices because for some potential homeowners this type of loan could be the only way to secure housing. In light of hot real-estate markets, the interest only loan can be a great option for someone who doesn’t think they will be living in their house for many years. The advantage to using an interest-only loan is when the homeowner sells the house they will be able to take advantage of any capital gains and may have been able to live in a house they normally wouldn’t have been able to afford. As GMAC Mortgage noted, “… first-time home buyers have been the biggest customers for this product” (Simon, 2006). Essentially this could be, as one writer noted, “a practical way up the property ladder –but only if you know all the risks” (Foley, 2006).

The major negative aspects of the interest-only loan revolve around the risk and management of the loan. One problem that is most commonly reported is that many potential borrowers don’t balance the lure of low payments they can afford now with larger future payments that they cannot afford long-term. An example given by one writer, Jon Gin of the Times-Picayune, follows. “Once the ‘interest-only’ part of the loan expires, say in five or 10 years, your mortgage payments can shoot up significantly, hundreds or even thousands of dollars more each month” (Gin 2005). The increase in mortgage payments is the result of the principal payments being re-amortized over the time left on the loan and added to the required monthly payment. (Mitchell, 2006) These values can be drastically increased if the interest-only loan also has an adjustable interest rate. If the rate increases during the full amortization phase, the payment will also increase. The payment shock that results when homeowners are not prepared for the increase in payments can hamper other financial goals, such as retirement and educational savings, even forcing some into bankruptcy (Gin, 2006).

Another negative is the delay in building of equity in the home. One of the major benefits of homeownership is the equity that is gained by making payments to the principal amount. When the house is sold the equity is returned. The argument is that if you are not going to stay in a home very long and the market is strong, the equity will be returned, even if you never make any principal payments. The opposite side of that, which is the most concerning for economists now, is the scenario where the value of the house stagnates or even begins to decline. The homeowners may have a loan on which they owe more then what the house is worth. In many cases this scenario would result in either bankruptcy or foreclosure, since few people could afford to pay the difference between the loan value and lower sale price. An example of this can be seen in certain markets that peaked in late 1989. When the homeowners sold their homes in the mid-1990’s their mortgages were higher than the value of their houses and they owned the bank money (Kass, 2006).

In support of the positive argument that many people don’t stay in a home long enough to reach the full payment requirements, Elinda Kiss, a professor at the University of Mayland, notes that on average people move every five to seven years, making the interest-only loan an attractive option (Mook, 2005). Although this may be true in many situations, the proposition has several risks involved, such as changes in job and family situations that would result in the family being required to stay in their current home without plans of how to meet the mortgage payment. This would be particularly true for those people who currently struggle to afford the initial interest-only payments (Mitchell, 2006).

Another negative of the interest-only loan is that they typically carry a quarter to a half of a percentage point higher interest rate. If the loan being taken out is large, even a small difference in interest rates can have a large impact on the overall cost of the loan (Gin, 2006).

I personally saw an example of interest-only loans being marketed aggressively when I toured my cousin’s house that he was building for resale in January 2005. The realtor had literature in the house that said, “Buy this house for $1100 per month” (Home for Sale, 2005). (I don’t remember the figures exactly but these are close approximations.) The value of the house was roughly $380,000, and this low of a payment for the approximate value made me curious. On the very bottom, in fine print, it stated that the loan was an interest-only loan with several specifics. They were marketing the property to be very affordable without having the actual price of the house written anywhere on the literature they were dispersing.

In October of 2005, the Department of the Treasury, Federal Reserve System, and Federal Deposit Insurance Corporation (FDIC), began a comment period information and data on non-traditional mortgage products including loans such as interest only mortgages. “These agencies were reviewing the rapid growth in mortgages and were particularly interested in loans that permit negative amortization, do not amortize at all, or have a loan to value greater than 100 percent. Their goal was to seek comment if these products should be treated in the same matrix as traditional mortgages or whether such products pose unique and perhaps greater risks that warrant a higher risk-base capital requirement” (FRBSF, December 2005). In essence, they were seeking comment to know if banks should be required to hold a higher amount of reserves to cover the perceived increase in risk, if there truly is more risk. In the docket sent to member banks in the 12th Federal Reserve district it was stated, “They (the agencies listed above) are also concerned that these products and practices are being offered to a wider spectrum of borrowers, including subprime borrowers and other who may not otherwise qualify for more traditional mortgage loans or who may not fully understand the associated risk of nontraditional mortgages” (Fed Letter, 2005). The drastic increase in the number of loans had many groups suspicious that more average homeowners were using these products rather then investors who have higher tolerances for risk.

The major reason that the agencies above are issuing a warning is two-fold. First, they are worried about the effect it has on the individual borrower. The risk that these borrowers are taking is important to consider. As noted by the National Consumer Law Center (NCLC), a consumer advocacy group, “The huge –and continuing –escalation of home mortgage foreclosures is inflicting devastating havoc on individuals, families and communities” (NCLC, 2006). They went on to advocate that it is the responsibility of the federal financial regulators to identify and decrease these foreclosures. From their prospective, the regulators should not only be worrying about protecting the risk carried by the lenders, but also the risk carried by the consumers (NCLC, 2006).

The other reason for the issuance of warning and guidance is for the potential effect that the interest-only loan trend could have on the economy. At the local level the NCLC argues each foreclosure has an effect on the local housing market. They quote the following statistic: “… from FHA foreclosures in Minneapolis, (the) estimated average city costs due to one foreclosure is $27,000, and neighborhood costs of $10,000” (NCLC, 2006). Even if the proliferation of non-traditional loans doesn’t result in foreclosures, many economists are worried it could still affect the economy as borrowers, struggling to meet required mortgage payments, will limit discretionary purchases. Tucker Adams, chief Rocky Mountain-region economist for U.S. Bank stated, “It would be a drag on the economy, but won’t cause a recession. It just adds to the threat of a recession and makes it more likely to happen” (Heilman, 2005). The President of the Federal Reserve Bank of San Francisco, Janet L. Yellen, was less concerned about the potential effects of these riskier loans. Yellen stated in a speech to a Portland leaders group, “I believe the odds of widespread financial disruption of this count (riskier loans) are fairly slim, although clearly, some borrowers are vulnerable” (Yellen, 2006). She went on to say that the rise of these products appeared relatively modest overall and that home valuations have risen faster than mortgage debt. Also she noted that some of the risk associated with mortgages, traditionally held by banks, have been transferred to investors through mortgage backed securities. She felt that these investors are in better shape to handle the risk (Yellen, 2005).