Mortgage Daily Logo
mortgage news from industry experts

Exotic Mortgage Analysis

Industry Commentary

Exotic Mortgage AnalysisBenefits, downside of interest only loans

August 31, 2005

By 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 DaveHershman@MortgageDaily.com.

Popular posts

How Long Does It Take to Refinance a Mortgage
How Long Does It Take to Refinance a Mortgage

So, you’re interested in refinancing your mortgage. Maybe you want some extra capital to do that home project you’ve always dreamed of, interest rates are nearing record lows, or you want to start consolidating debt. Regardless of the motivation behind the refinance,...

How Does Refinancing a Mortgage Work
How Does Refinancing a Mortgage Work

A home purchase is considered an investment, and a robust one at that. Savvy owners are constantly looking for new ways to reduce debt, save money, pay less in interest, and ultimately build equity. Refinancing is one way to leverage your investment and do just that....

What Does It Mean to Refinance Your Home
What Does It Mean to Refinance Your Home

You can think of refinancing your mortgage as a debt redo. Essentially, you’ll swap out the existing loan for a new one - ideally with better terms and conditions. Only this time it could help you save money on high mortgage payments, rather than just borrow it....

Setting up the Utilities in My New House
Setting up the Utilities in My New House

All the tedious, time-consuming home closing documents have been signed, sealed, and delivered. Your belongings are packed into what seems like a million boxes and you have a solid plan to haul all your existing furniture to the new place. Just as your boxes and...

When Is My First Mortgage Payment Due?
When Is My First Mortgage Payment Due?

Navigating your way through a brand new mortgage loan can be a difficult task, especially for first time homeowners. After handing over a large sum of money for the down payment and closing costs, it’s important to pay attention to the timing of your first mortgage...

Newsletter

Don’t worry, we don’t spam

calculate your monthly mortgage payment

Related Topics

Helpful Links

Daily mortgage rate trends

Best mortgage lenders

First-time homebuyers programs by state

Loan limits by state

Types of mortgages

APR vs interest rate

Understanding PMI

Related Posts

THE TRUSTED PROVIDER OF ACCURATE RATES AND FINANCIAL INFORMATION