Interest-Only: Borrower Beware

Steve Clerman refinanced his Montgomery Village townhouse with an interest-only loan last year. Feeling financially trapped, he now says,
Steve Clerman refinanced his Montgomery Village townhouse with an interest-only loan last year. Feeling financially trapped, he now says, "I'm in a really lousy mortgage." (Katherine Frey - Twp)
By Kirstin Downey
Washington Post Staff Writer
Wednesday, December 21, 2005

Steve Clerman decided to refinance his townhouse in Montgomery Village back in 2003. One offer jumped out at him from the flood of loan solicitations that arrived in his mailbox, and he signed up for an interest-only, adjustable-rate mortgage.

It was a relatively new type of loan, tempting to him and a growing number of people because it required very low monthly payments in its early years, since none of the money was used to pay off the loan's principal.

Now, though, Clerman feels trapped in a mortgage he says he didn't understand. In the past year, his interest rate has risen from 4.5 percent to 6.5 percent, and it is likely to head higher. Meanwhile, he has just looked at the loan's fine print and realized that he is locked into it for five years: If he tries to refinance or sell the home during that period, he owes the lender a $4,900 pre-payment penalty.

"I think I'm going to sell and get whatever I can for it," said Clerman, 50, an insurance salesman. "I'm in a really lousy mortgage."

Banking regulators share Clerman's concerns. The federal government yesterday announced that it was considering new restrictions on these nontraditional loans. Lenders would be expected to require borrowers to have higher down payments and better credit, to verify their income, and to be able to withstand a future payment increase, according to proposed "guidance" from the regulators. Lenders would also be required to explain the loans more carefully to borrowers.

"Too many consumers have been attracted to products by the seductive prospect of low minimum payments that delay the day of reckoning but often make ultimate repayment of the growing principal far more difficult," John C. Dugan, comptroller of the currency, said in a recent speech. "At the same time, too many lenders have been attracted to the product by the prospect of booking immediate revenue without receiving cash in hand, a process that often masks underlying credit problems that could ultimately produce substantial losses."

Millions of Americans in recent years have bought or refinanced their homes using variants of these loans -- either interest-only or other mortgages that permit people to decide how much to pay each month. In 2000, only 1 percent of Americans who got new loans selected the interest-only variety, but by midyear 2005, about 23 percent of borrowers were using them. In fact, a greater proportion of buyers used them in the District than in any state, according to LoanPerformance Inc., which reported that in the first half of 2005, 54.3 percent of all D.C. home purchasers used interest-only loans.

But now that the rates are rising, some people are finding themselves seriously strapped.

Lauren Hillman, an editor with a nonprofit group, bought a three-bedroom condominium in Reston for $250,000 in September 2004. At the urging of a friend and a mortgage broker, she took out two adjustable interest-only loans, one for the main mortgage and one for part of the down payment. The interest rate on the smaller loan started gyrating almost immediately, month to month, she recalled, climbing from 5.375 to 9.25 percent. She juggled bills and pared her expenses to the bone to handle the payments.

"It was a lot more debt hanging over me than I realized," Hillman said. "In the preapproval process, they say you can afford a lot more than you think you can, but that's a lie. It's only with eating ramen noodles and not doing anything but go to work and come home."

With the monthly price tag and the threat of her mortgage balance rising at the same time, Hillman grew increasingly nervous, she said. She eventually got a second job, took on a roommate and refinanced last month into a fixed-rate loan.

Interest-only loans were developed for high-income people who wanted to manage their cash flow. But their popularity soared, especially in high-cost areas such as the Washington region, because they help people afford homes they otherwise couldn't buy. Now, throughout the region, more than a third of borrowers this year have obtained them.

CONTINUED     1        >

© 2005 The Washington Post Company