In the days leading up to the spring closing date on Jonah Davenport's two-story condominium in Columbia Heights, he and his fiancee were growing increasingly anxious about their upcoming $2,600 monthly mortgage payment. They were discussing cutting back on their wedding, scaling down their honeymoon and renting out their second bedroom.
Then they found out about an interest-only loan.
Two days before closing, Davenport was able to switch to a five-year, interest-only, adjustable-rate mortgage (ARM) from a 30-year, fixed-rate loan. The change saved him about $700 a month, decreasing his payment to a relatively affordable $1,900. "This way, we could have money in hand to actually live," he said. "We have a lot more flexibility."
As home prices climb, many buyers are turning to interest-only loans to reduce mortgage payments and gain more financial freedom. But some experts caution that there are home buyers who don't fully understand the risks and don't possess the fiscal discipline needed to handle such loans.
The idea behind an interest-only loan is simple: Borrowers are not required to pay down any principal for a fixed number of years. For example, on a 30-year mortgage with a five-year interest-only ARM, the borrowers would pay no principal for the first five years. For the remaining 25 years, they would have significantly higher payments, compensating for the first five years. Interest-only options are also commonly offered for a 10-1 ARM or for a monthly adjustable rate. With a 10-1 ARM, the interest rate is fixed for 10 years, then adjusted every year thereafter.
The biggest upside to an interest-only loan is the smaller payments. The downside is that homeowners are building equity by appreciation only -- not by paying down the principal. Depending solely on appreciation, homeowners could be left without much cushion if the market stumbles.
If the market shifts and they must sell their house for less than they paid for it, those with interest-only loans will have no equity and will owe the bank the difference. Even if there has been some price appreciation, selling costs such as real estate commissions could wipe out any profit.
"There are bear markets in housing just like bear markets in stocks," said Ruth Hayden, a financial consultant based in St. Paul, Minn. "In the short run, banking on appreciation is risky."
Interest-only loans are not a new idea. In fact, such loans were standard during the boom market of the 1920s.
When the Great Depression hit, however, foreclosures skyrocketed. That economic disaster made the long-term amortized mortgage -- the 30-year loan with a gradual pay-down of principal -- the U.S. favorite. Until recently, in this country interest-only was an option used only by real estate investors.
But as home prices have skyrocketed in recent years, banks have started to sell interest-only packages to mortgage brokers for consumers. In most cases, customers pay a slight interest-rate premium for an interest-only option, anywhere from 1/8- to 1/2-percentage-point above the same loan with standard amortization. Banks also require higher credit scores to reduce the increased risk of an interest-only loan.
Mortgage brokers say interest-only loans have really taken off in the Washington area in the past 18 months, after the dramatic price appreciation here. "There's a direct correlation with house values," said David Auer, president of Universal Trust Mortgage Corp. in Pikesville, Md.
For many local mortgage companies, interest-only loans make up an ever-increasing share of their business. Mark Townsend, president of Townsend & Halbrook Mortgage Corp. in Rockville, said half of his transactions are now interest-only. Fundy Kasuri, senior mortgage banker at Buckingham Mortgage in Tysons Corner, estimated that interest-only loans make up about a quarter of his business.
Financial planners agree that for homeowners with lots of assets, interest-only loans can be wise. There are no prepayment penalties on interest-only loans, so homeowners always have the option of paying down the principal. Having other savings or investments available would help absorb the shock if a homeowner had to sell at a loss.
Thomas C. Grzymala, a certified financial planner and principal at Alexandria Financial Associates Ltd., was so impressed with the concept that he got an interest-only loan for his new semi-retirement home on a Charlottesville golf course. Grzymala said he would have been able to afford the house anyway, but thinks he can make more money without a principal payment.
"Being a professional money manager, I can do a little better," he said. "I can take that difference and use it for other purposes."
The popularity of interest-only loans also reflects the realization among many buyers that they will never actually own their homes. Nationally, less than half the people with 30-year mortgages stay in place long enough to pay off that loan.
Tim Meinhardt used an interest-only loan three years ago, when he moved into an $800,000 house in Rockville's Manor Park from a smaller home in that neighborhood. When he recently refinanced, he continued with the interest-only option, preferring to invest the money rather than pay down principal. "We don't have any intention of paying the house off," he said. "All we wanted to do was get the lowest monthly payment."
In addition to the wealthy, interest-only loans are often recommended for people who fall into three other categories.
The first are those whose income will jump, such as medical students. The second are those who are confident of their home appreciation, such as Davenport, who will soon have a new Target, movie theater and Giant supermarket within blocks of his Columbia Heights condo. The third are those who know they are staying for only the short term, meaning they wouldn't pay down much principal anyway and will move before the interest-only period is up.
Take Eric Mauro, district security manager in Laurel for United Parcel Service Inc., a company known for frequently moving managers. When he was transferred to Maryland from Buffalo last year, he received a rude awakening in house prices. Thanks to UPS stock and an interest-only loan, though, he was able to afford a 3,700-square-foot, five-bedroom house in Ellicott City. "Potentially, I could get relocated every couple of years," he said. "You do it this way, you get a bigger bang for your buck."
Another category of homeowners, however, worries some financial planners. Those are the people who don't have many assets and who couldn't afford their house except for an interest-only loan.
"Don't agree to stretch your mortgage out to the limit to buy a more expensive home," said Keith T. Gumbinger, vice president at HSH Associates, a New Jersey financial publishing firm.
Gumbinger said such homeowners often intend to save money that would have gone to principal but have trouble following through. "A lot of people will go out to dinner or go out and buy a boat instead," he said. "You can do better, but will you do better? It's: 'Borrower, know thyself.' "
Grzymala, however, believes that interest-only loans are right for almost anyone who can qualify for one, even if that means moving into a house that they couldn't otherwise afford. With the tax deduction for mortgage payments and the current appreciation rates, he said, "interest-only loans are a very, very good opportunity for people who can't afford the whole enchilada."