Okay, so what's wrong with interest-only mortgages?
At a time when house prices are soaring in many markets, "IO" loans, as they're often called, are becoming quite popular, and for obvious reasons. They offer lower initial payments that make it easier for buyers to qualify for their loans or that free cash for other purposes.
As the value of the house continues to rise, the buyer gains equity that can be cashed in by selling or refinancing a few years down the road. The loan gives the first-time buyer a boost on board the housing wealth train, so he doesn't languish in the rental station as the train speeds off without him. And it offers investors the ability to buy a second home or rental property and rack up big capital gains.
It sounds great, and thousands of buyers across the nation, and especially in hot markets like Washington, have signed onto IO loans for just those reasons. IO loans have constituted more than a third of the home mortgages in the Washington area this year -- and 54 percent of those in the District -- according to LoanPerformance, a housing data firm based in San Francisco.
But many newspapers, including this one, wet blankets that we are, have been suggesting that IOs may not be the greatest invention in financial history. Why? Because, while the wonderful things said about IOs may be true, the folks peddling these loans often leave a key factor out of the equation: risk.
In fact, IO loans are bringing to the housing market a risk factor that few home buyers have faced in the past, creating the potential for a whole class of owners who could, five or so years from now, find themselves unable either to make their mortgage payments or to sell their houses.
It's a peril that worries Federal Reserve Chairman Alan Greenspan. And if it worries him, it should worry you.
"The dramatic increase in the prevalence of interest-only loans" is a development "of particular concern," he told a congressional committee last week.
Historically in the United States, house purchases have been financed with long-term, fixed-rate mortgages. These loans allow buyers to lock in their mortgage cost on Day One, and they keep paying that same amount for decades. Market interest rates may soar, house prices may plunge, but the owner can simply hunker down, make the payments and live in the house.
These loans don't eliminate all risks, of course. Loss of income, or an untimely job transfer that forces an owner to sell, can result in losses or foreclosure. The risks are greater with conventional adjustable rate mortgages, which have become more common in recent years, but at least ARMs typically have caps on the amount the rate may rise, providing a shield against extreme situations such as the double-digit rates of the 1980s.
IOs, though, often have a kind of cliff that a borrower can run into (or fall off of, depending on how you like your metaphor). Their closest counterparts, "balloon" mortgages, in which the entire principal is due after a certain length of time, have never been very common in home sales.
While these loans can be structured many ways, a typical IO will require payments of interest only -- no principal -- for a period of years at the beginning, followed by a period in which the loan "amortizes," meaning that the borrower must begin making payments large enough to pay off the principal, along with interest, over the remaining term of the loan.
The expectation is, of course, that before the end of the interest-only period, the borrower will refinance or sell.
If things have gone according to plan -- meaning if the house price has risen and interest rates have not -- this is no problem.
But if something goes wrong -- and historically what goes wrong in the housing market is the interest rate -- the owner could end up between a rock and a hard place.
If the loan is for 30 years, with the first five as IO, then the balance typically is paid off over the final 25 years. This means that the payments from that point on would be higher than they would have been at the beginning of the loan because the amortization period is shorter. If the loan is variable and rates have risen, the payments will be higher still.
For example, a $300,000 loan at 5 percent would have interest-only payments of $1,250 a month. After five years of IO payments, the borrower would still owe $300,000. At the same 5 percent rate, payments at that point would jump to $1,754 a month for the remaining 25 years. A big jump, but perhaps doable.
But suppose the loan has a variable rate, and five years from now rates have climbed to 7 percent. The monthly payment goes to $2,120. At 10 percent -- a rate we hope never to see again but one that was in effect during much of the 1980s -- monthly payments would be $2,726.
For wealthy and sophisticated buyers, who can use the cash they save from the lower payments to make other investments and who could make the higher payments if they had to, IO loans can be useful financial tools.
But buyers who need an IO to afford the payments are betting heavily on continued low interest rates and higher home prices.
And if rates do rise, home prices may not. Since house prices tend to reflect the payment that buyers can make, rising rates, since they raise the payment, tend to depress prices.
Of course, other factors can cut prices as well -- such as excess construction, or a slump in a region's economy.
If prices fall substantially, some sellers will not be able to get enough for their property to cover the loan balance. In that case, they must either bring cash to the settlement table if they sell, keep making the payments, or face foreclosure.
Data show that a large share of recent housing sales, including many with IO financing, involve second homes and investment property.
Investors like IOs because the low payments "make the numbers work," meaning that the rents cover a property's costs. But the kinds of swings that could happen in a climate of rising interest rates could reverse that, and as anyone who has had to subsidize a rental property month after month knows, that's no fun.
And that brings up another risk: Home mortgages usually give lenders recourse against the borrower's other assets, not just the house. This means that if the lender forecloses and the value of the property doesn't cover the loan balance, the lender can go after the borrower's other assets.
Lenders don't usually do that, mostly because foreclosure sales cover all of the note or so much of it that pursuing the borrower isn't cost-effective. But if things get really bad, the option is there.
Home buyers should be using today's very low rates to lock in their mortgage costs, not relying on exotic financing deals to buy a more expensive house. Harvard economics professor Martin Feldstein once described the 30-year fixed-rate mortgage as "a peculiar sort of one-sided bet," in which the borrower wins if rates go up, but gets to place a new bet -- refinance -- if they go down. It's the kind of bet a home buyer can truly love.
Five people associated with a group known as "We the People" who sold books and other material that purported to show buyers how they could legally escape tax were sentenced to federal prison last week.
The leader of the operation, Lynne Meredith, 55, of Sunset Beach, Calif., got more than 10 years based on her conviction last year on charges of mail fraud, using a false Social Security number, making a false statement in a passport application and failing to file a tax return.
U.S. District Judge Dean D. Pregerson, in sentencing Meredith, called her ideas on federal tax laws "delusional." Among other things, evidence showed that Meredith sold books and bogus "pure trusts" to people for $500 to $1,000 apiece, telling them they could legally shield income and assets from taxation. Meredith and her co-defendants helped taxpayers by opening bank accounts with phony taxpayer identification numbers, filing fraudulent income tax returns and encouraging taxpayers to stop filing income tax returns.
Fidelity Investments' Charitable Gift Fund, a "donor-advised" charitable giving fund, has given more than $5 billion in grants to more than 88,000 charities recommended by the fund's donors, Fidelity said. The fund was founded in 1991.