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Interest-Only Mortgages Might Work For Some People, But Know The Risks
Tommy
Whether you wanted relief for your mortgage payments because of Covid-19 or if you are in the market to buy a home and you need a loan. Many banks are “helping” their customers in their minds by providing payment relief in terms of loan modifications or offering interest-only (I-O) mortgages. Now I work in commercial banking and I will tell you that “helping” is only somewhat true.
Mortgages are important to our customers. For most of our customers, their home is the single largest purchase they will make in their lifetime.
Covid-19 Relief
With Covid-19 some lenders are offering payment relief via loan modifications. Your typical monthly payment is a principal and interest payment (P&I). Principal payments reduce the principal balance or the amount that you owe to a lender. Interest payments are paid to the lender who lent you the money and is a cost of doing business. These loan modifications offer I-O payments indefinitely or for a set period of time. In theory and most of the time, your I-O monthly payment will be lower than your monthly P&I payment.
Providing I-O payments as payment relief really only helps in the short-term or less than a year. After that period, you should try to return to normal payments as soon as possible. The problem is that when you don’t pay down the principal balance and make the minimum I-O payments, then your payments become more expensive because of compound interest. This can cause financial strain on the borrower in the future.
Interest-Only Mortgages
Your standard home mortgage is a 30-year fixed rate loan and you make P&I monthly payments. You might even make escrow payments for property taxes and insurance. These payments will be found on an amortization schedule. Amortization just means paying down a loan over time. The longer the amortization, the lower the monthly payments will be.
On the other hand, I-O mortgages are where you make I-O payments for a set period of time usually at the beginning of the loan or introductory period. This is typically anywhere in between 1-10 years. During that initial period, you are not required to make principal payments. If you only make I-O payments then you will owe the same amount of money as you did at the beginning of the loan. What lenders don’t say is that when you don’t pay down the principal balance, you will pay more interest over time as interest compounds.
Let’s compare an I-O mortgage and a conventional mortgage.
You received a 30-year I-O loan at a 4% fixed rate with a loan balance of $250,000 and there is a 10-year I-O period. The minimum payments are I-O at $833/month. At the end of that 10-year period, assuming you had paid nothing toward the principal balance and the interest rate stayed at 4%, your payment would jump to $1,514/month based on a 20-year amortization schedule. This is a combination of principal and interest payments and does not include escrows for property taxes or insurance. The main reason for why the monthly payment jumps is because of the addition of principal payments at a 20-year amortization when a conventional loan is a 30-year amortization. If you made zero principal payments during the 10-year term, you will pay $213,588 in interest over time.
By comparison, a 30-year fixed rate $250,000 conventional mortgage at 4%, your monthly payments will be $1,193 and you will pay $179,674 in interest over time. You would save $33,914 in interest with a 30-year conventional mortgage.
What you don’t want is what happened during the 2008 financial crisis. Borrowers experienced a payment shock like above when switching from I-O payments to P&I payments. Some were not creditworthy to make the P&I payments, but were given loans anyway. Also, many lenders were not responsible with who they lent money to and had very relaxed underwriting standards or loose credit. This loose credit included not performing background checks, not performing credit checks, and even not verifying income. This was because the lenders became greedy and everyone thought that the real estate market would never go down. Oops… Just watch The Big Short!
Who Benefits?
There are only a specific few people who would benefit from I-O loans. Typically they are only good for people who plan on moving in a few years and will sell their home within the I-O period before the P&I payments come due. They benefit by having to pay less in monthly payments and then pay off the loan when they sell their home. Another situation would be when people go through a divorce and one spouse is buying out the other’s interest in the home and needs affordable payments to not default on the loan. Then they plan to sell the home later. Remember that I-O mortgages lower the payments for a set time period, but then increase substantially when that period is over.
Truth be told. In a capitalistic economy, lenders are offering a product, create the rules, and they assume you have done your due diligence to choose the product that is best for you. By law, we disclose all of the information and we expect you to read it, no matter how small the fine print is. You then enter a contract with us and we expect you to honor that contract by repaying the debt in full.
The majority of lending is not abusive or wrong and we actually give you the opportunity to own a home/real estate. But you have to do your homework to do what is best for you. When you don’t do this, you are being irresponsible. Owning real estate is an investment and you have to have skin in the game.
Moral of the story is that I-O loans will work for some people, but not all people. You have to know the risk involved with these types of products and it’s your duty to learn about these products.
Featured Image: David McBee.