by Bradley Parsons
Staff Writer
A new mortgage trend is sparking lots of interest among lenders and borrowers.
Interest is the operative word, because it’s the only monthly payment borrowers have to worry about. Interest-only loans allow borrowers to defer payments on their principal as much as 10 years down the road.
The loans are popular with borrowers because of the reduced early payments. Lenders see the loans’ growing popularity as an avenue to grab a bigger chunk of the mortgage market. Five years ago the loans were uncommon. Now about one in 10 mortgages are interest-only. Locally, some lenders are using the loans with even greater frequency.
Brad King, an executive with Wachovia’s mortgage office, estimated that nearly a third of the bank’s local mortgage business is interest-only.
“It’s been available before, but it’s becoming more prevalent, more of a mainstream option,” he said. “It’s helping fuel the housing boom.”
And the lending boom as well. King said interest-only mortgages are a key tool in Wachovia’s strategy to boost its share of the national mortgage market. Wachovia already has the largest share — about 38 percent — of the local market.
Interest-only loans represent a new approach to mortgage lending. It used to be that a borrower needed a 20 percent down payment and a favorable credit rating to buy a house. But with housing markets booming across the country, banks are
looking for ways to increase their mortgage market share by making the loans accessible.
“If you don’t have 20 percent down, it doesn’t mean you can’t get a mortgage anymore,” said Gil Pomar, president and CEO of Jacksonville Bank. “Now, if you’re a little bit more of a credit risk, you might get charged 9 percent instead of 5 percent. But at least it’s not a no.”
Similar to making a minimum credit card payment, the reduced early payments on interest-only loans leave more money in borrowers’ pockets. It’s what they do with that money that usually decides whether interest-only loans lead to success or disaster.
The early payments are cheaper because the principal sits untouched. But once the interest-only term expires — five, seven and 10-year terms are typical — the payments balloon. With the principal suddenly included, monthly payments can double.
The loans make sense, lenders and financial advisers say, if the borrower expects a rise in income, if the borrower is paid infrequently like through commissions or bonuses, if the borrower invests the money saved, or if the borrower intends to sell or refinance the house before the interest-only term expires. The lower monthly payments also appeal to business owners who need to free up cash.
In those circumstances, the loans can be a good investment. A borrower could save about $300 a month by paying interest-only on a $400,000 loan at 7 percent interest. By deferring payments on the principal, the borrower is saving about 3 percent on the monthly payments.
If that money is invested in a retirement plan or other diversified investment earning more than 3 percent, the interest-only loan could be a money maker. But if the money instead goes into car payments or other lifestyle expenses, the borrower will face a heavy bill when the principal comes due.
Borrowers also get into trouble if they use the loans to buy more house than they can afford, if they spend their savings frivolously, or if housing prices tumble.
“The danger, of course, is if the (interest) rates go up and the music stops, and house values stop going up or potentially go down,” said Pomar.
That could leave borrowers overextended if they buy a house outside of their price range. Drops in housing prices are a threat because they effectively remove the option to flip the property. A borrower with a $400,000 mortgage on a home suddenly worth $300,000 can’t sell without taking a huge financial hit and will likely have to refinance or else pay the balloon payments on the principal.
But lenders don’t see any evidence of Jacksonville’s housing market heading south. King noted that the market’s new house inventory is still low despite an ongoing construction boom. That indicates strong demand, he said.
Pomar said he hasn’t seen a serious dip in the market, “in a long time.” The conditions that make Jacksonville a hot market — nice climate, low taxes, pro-business environment — aren’t going away, he said.
Rick Brown, vice president and area sales manager for Countrywide Home Loans, sees no inherent risk in borrowing interest-only. Even without building up equity by paying down the principal, local homeowners are likely to see their homes appreciate, he said.