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Industry Commentary


Exotic Mortgage Analysis

Benefits, downside of interest only loans

August 31, 2005

By DAVE HERSHMAN


photo of Dave Hershman

While many factors have contributed to the greatest real estate boom of all-time, including record low interest rates, booming immigration and less confidence in the stock market, no factor has been more important than the influx of new mortgage programs.

Just twenty years ago, if someone wanted to purchase a home, a potential buyer had to put five percent down and there were no "no-closing cost" loans. The menu of adjustable rate mortgages were limited and those who had bad credit had to pay interest rates approaching 20.0%.

Today, we have "no-money down" programs, no point mortgages and affordable alternatives for those with hard to document income and those with uneven payment histories. And there are many choices with regard to ARMs. Some of these are quite innovative and we will call these "exotic" mortgage products.

Foremost among the exotics are interest only loans and option ARMs. Since some option ARMs can be paid on an interest-only schedule, we can say there are some of each and those that cover both categories.

Interest only mortgages, a product that was barely available five years ago, has grown to over 25.0% of the real estate finance market according to recent statistics. That is quite a record of growth. It is no wonder that this product is popular because those who obtain IO mortgages can have a payment which is up to 30.0% less than fully amortized mortgages. With housing prices skyrocketing, many have opted for this innovative mortgage instrument.

The National Association of REALTORS has recently issued a brochure warning consumers of the dangers of these exotic products, including IO loans. The Chairman of the Fed Reserve has also noted this issue as have government regulators.

We have fueled a real estate boom using these products. But are they dangerous?

To answer that question, one would need to look at two aspects of IO mortgages. First, the fact that the loan is not amortized or "paid down." Second, the fact that the loan is typically tied to an adjustable rate mortgage.

The chart on this page compares an interest only loan to a 30-year amortized loan over a five-year period.


$200,000 Interest-Only Mortgage
at 5.0% vs. 30-year Amortization
Interest
Rate

Monthly
Payment
Monthly
Difference

Difference
Over 5 years

Amortization
After 5 Years
5.0% $1073.64
30-Year
+$240.31 +$14,418.60
extra payment

$183,657.46
5.0% 833.33
interest only
N/A +16,342.54
extra balance
$200,000.00


We have chosen this five-year period of analysis because many IO mortgages are 5/1 adjustable rate loans. This means that they are fixed for five years and then convert to a one-year ARM. Also, in eras of low rates and high levels of refinancing, the average life of a loan can be shorter than this five year period.

What is the savings on an interest only over five years? It is $14,418.60 or 22% of the payment. Of course, this savings comes at a cost. The 30-year mortgage will have a lower principal balance after five years, $183,657, or a $16,342 difference.

What does this mean? If the consumer is to sell the home in five years, they would receive $16,342 more out of the proceeds of the sale or slightly more than they have saved. Or, they can refinance at 7.0%. This assumes that rates have risen which is the concern of the critics of these mortgages.

Next month we will look at this option and the affect of ARMs with regard to long-term risk.


Dave Hershman is a mortgage industry author and speaker -- with 8 books and hundreds of articles to his credit. He also heads OriginationPro.com Mortgage School. You can email Dave at [email protected].


click here for more articles by Dave Hershman



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