Is an interest-only loan right for you?
Few loan products have attracted the attention, both of home buyers and media types, as have interest-only mortgage loans. These products, thanks to the lower monthly payments they boast, are soaring in popularity across much of the country, including the Chicago area.
The question, then, is simple: Is an interest-only mortgage loan right for you?
The answer to this question, not surprisingly, isn’t as simple. Local mortgage pros say it all depends on the borrower. While an interest-only loan is perfect for some home buyers – notably those who are paid large sums of money on an irregular schedule – they may not be the best option for others. The only way for a home buyer to know if an interest-only loan makes sense? That buyer should consult a mortgage loan officer familiar with the product.
Interest-only loans are popular these days, especially in bigger markets such as Chicago, because they offer consumers the benefit of low monthly mortgage payments.
Here’s how such loans work: Borrowers who take out interest-only loans initially pay down only the interest on their loans when they make their monthly mortgage payments. This arrangement lasts for a set period of time, usually five to seven years. After that period ends, borrowers can either refinance their loan into a different form – perhaps a standard 30-year fixed-rate loan – pay the loan balance in a lump sump or start paying off the principal on their existing loan. The problem with that last option is that the monthly payments suddenly jump. Not surprisingly, most homeowners choose the refinance option.
Because of the way interest-only loans work, mortgage consultants recommend them for only a certain kind of borrower. Borrowers whose income comes mostly from irregularly scheduled commissions or bonuses, those who expect to earn a much larger salary in just a few years and those who are skilled enough investors to make wise use of the money they’ll save by making smaller monthly mortgage payments are good candidates.
Those borrowers who have a standard pay schedule from their employer and are not experienced investors should probably look toward another loan product, say financial experts. And with the wide variety of mortgage loans now available – everything from loans that require no down payments to those that provide significant discounts to the owners of energy-efficient homes – borrowers should have no problem finding an alternative if an interest-only loan isn’t right for them.
"These loans can become dangerous tools when borrowers use them to qualify for a loan or to get into a home that they otherwise could not afford. And unfortunately, we are seeing a lot of that taking place," said Greg McBride, senior financial analyst with Bankrate.com, an online financial news source. "They make the most sense for borrowers that could otherwise afford a fully amortized loan payment but instead prefer interest-only because it allows them to maximize their other investment opportunities."
There is solid statistical evidence that interest-only loans are gaining in popularity. McBride says that 15 percent of all new mortgage loans are now interest-only loans. That accounts for a solid portion of the mortgage business, and a good chunk of money considering that officials with the Mortgage Bankers Association of America expect mortgage loan officers to originate $2.5 trillion worth of mortgage loans this year.
Chief economist and senior vice president of the bankers association, Doug Duncan, earlier this year pointed to interest-only loans as one of fastest-growing mortgage products among consumers.
"These loans are especially interesting, and extremely popular these days," Duncan said. "They are attractive to people who are stretching to get into a house. The question you have to ask if you are interested in one of these loans is, ‘Will my income levels probably grow in the future?’ If the answer is ‘yes,’ then there is probably no risk for you to take out an interest-only loan."
Officials with Bankrate, though, caution that an interest-only loan doesn’t make financial sense when buyers are going after a lower-cost home. In a feature story on interest-only loans, Bankrate uses this example: If a buyer takes out a mortgage loan of $200,000 at 7 percent interest, the savings from an interest-only loan for the first three years would come to less than $200 a month. If that loan amount stood at $400,000, though, at the same interest rate an interest-only loan would save a borrower more than $325 in the first month of the loan.
Because of the intricacies involved in an interest-only loan, local loan pros recommend that home buyers read up on the loans or talk to a mortgage professional before making any decision regarding them.
