Interest-Only: Borrower Beware
Popular but Risky Mortgage Draws Government Scrutiny

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.

Lenders say such loans make sense for some people, including those whose homes have risen in value so much that they are sheltered even if prices fall, people with high but irregular incomes, such as commissioned salespeople; and people who face a sharp temporary cash squeeze.

A traditional loan, with a fixed rate for 30 years, would cost $1,847 per month for a $300,000 loan at 6.25 percent. The interest rate stays the same for the life of the loan, and each monthly payment is split between covering interest costs and the principal.

Payments on a $300,000 interest-only, adjustable-rate loan would be just $1,562 per month because none of the money in the early years is used to reduce the principal amount and the borrower, not the lender, is taking the risk that interest rates will rise. There are even more risky loans being offered, ones that start with rates as low 1 percent and quickly adjust -- the payment on a $300,000 loan of that variety could be just $965 a month at the start. Then, after a set term -- usually three, five or 10 years -- the borrower must begin paying the principal, which can double the monthly payment.

If the borrower cannot afford those higher payments, a vicious cycle could begin:

In many of these loans, because the borrower is not paying the full monthly interest expense, that shifts to the mortgage balance, meaning the balance owed goes up, not down, as it does in a conventional loan. This is called negative amortization.

Then, if home values fall, borrowers might not be able to sell their houses at a profit to get out from under the bigger mortgage payment. That would mean they could lose their homes to foreclosure.

If loans do go into foreclosure, banks could lose money. If too many loans go into foreclosure, banks could fail and be required to tap the federal insurance fund. If the insurance fund runs dry, taxpayers could ultimately be on the hook, as they were when many savings and loans failed in the 1980s and 1990s.

Some lenders say that interest-only loans meet a need and that if borrowers end up with problems, they have only themselves to blame.

"It's not the best way to buy a home, but for some people, it's the only way," said mortgage broker Christopher Cruise, who trains brokers for large lenders. He said some people fail to educate themselves before taking on what will be the single largest investment of their lives and then wail about the mistake they made.

"People spend more time researching the flat-screen TVs they buy than their home mortgages," he said.

But Jack Guttentag, a retired professor of finance at the University of Pennsylvania's Wharton School of Business, whose Web site, http://mtgprofessor.com/ , offers borrowers advice and information, said it is easy for buyers to be duped.

"There are a lot of hustlers in this market who induce people to take loans that are not in their long-term interest," he said.

Some people, however, say they are pleased with their interest-only loans. Archivist Suzanne Adamko, 32, refinanced her Beltsville townhouse in May with an interest-only loan that has a fixed rate for seven years -- and she intends to refinance to a fixed rate or move during that time. Although she is required to pay only the interest, she adds about $250 a month to the payment, which more than covers what she would pay toward principal with a standard loan. Her mortgage balance is declining while home prices are rising.

"I thought I wanted a 30-year fixed mortgage, but my financial adviser said, 'That's your father's mortgage,' " she recalled. "He said, 'You may not be in the house that long,' so I could take advantage of the other options open to me."

Clerman, however, said he wishes that he had never gotten the interest-only loan and that he hadn't been so "wowed" by the initial low rate. "There are some people out there getting crushed with these interest-only loans," he said.