One of the most popular home mortgages this year could also prove to be one of the most toxic to the unwary: low-down-payment, short-term "interest-only" adjustable-rate loans.
Designed to allow consumers to stretch their incomes and qualify to buy homes at below-market starting rates in the range of 4 to 5 percent, these mortgages come with built-in time bombs: After the initial three- or five-year fixed-payment, interest-only period ends, they morph into standard-payment adjustables with full contributions to principal. The biggest time bomb is the first monthly payment after the interest-only period, which may be 30 to 70 percent higher than earlier payments.
Mortgage brokers say that many buyers are oblivious to the lurking payment shocks or simply have no plan to deal with large increases in monthly expenses. Other buyers appear to be betting on real estate appreciation to bail them out -- not a wise strategy at the end of a decade-old price boom.
Interest-only mortgages traditionally came with extended periods -- 10 years or more -- where no principal reduction was required as part of the monthly payment. But lenders have begun pushing short-term, interest-only plans to qualify more home buyers in a rising-rate environment.
In an interest-only plan, the lender sets a come-hither fixed payment rate -- for example, 4.5 percent -- to pull in customers. During this initial period, payments are low because none of the payment goes toward reducing the principal balance. Most interest-only three- and five-year plans convert from fixed-payment to an adjustable rate -- reset annually or monthly -- for the remaining term of the loan, usually 25 to 27 years.
After the initial period, contributions toward principal reduction begin. That feature alone almost guarantees higher monthly payments. Also, in an environment of rising interest rates, the index governing the loan payments can jump unpredictably, sometimes raising the mortgage rate as much as 5 percentage points, the "cap" typically included in the plan.
Even a modest 1-percentage-point increase in market rates at the end of the interest-only period can produce hefty jumps in monthly principal and interest payments.
Consider this illustration: Your lender offers a five-year interest-only loan at 5.25 percent that converts to a one-year adjustable after 60 months. Even if rates stay flat during the 60-month interest-only period -- not likely in the current economic scenario -- you will still get hit with a 30 percent payment spike when principal reduction kicks in. If market rates increase just 1.5 percentage points, your monthly payment will jump 50 percent. A 2.5-percentage-point jump would push your payment up 64 percent.
Could you afford a mortgage payment that is 64 percent higher 60 months from now? Some mortgage brokers and lenders say they worry that many home buyers who are now taking out short-term, interest-only loans could not. Nor would they necessarily have easy refinancing or resale options, especially if home real estate appreciation rates flatten out or fall.
"Some of these people think real estate values can only go up and interest rates only stay low," said Philip X. Tirone, executive loan officer with First Capital Mortgage in Santa Monica, Calif. They don't realize how quickly superheated housing markets can cool off, he said, noting that Southern California home values fell 20 to 30 percent in the early 1990s following the sizzling 1980s. Though Tirone says he frequently talks clients out of short-term, interest-only programs, some tell him that they have no other way to "get in on this real estate boom and make a lot of money quickly."
Without substantial increases in household income, Tirone said, "a lot of these [interest-only] borrowers could be looking at potentially big trouble" in three to five years.
Some major institutional players in the home mortgage market agree. The top credit official for mortgage insurance giant MGIC Investment Corp., David Greco, believes that while short-term, interest-only adjustables "can be very useful tools" for well-informed consumers, "they can pose a substantial risk to an unknowing, unprepared borrower."
The risks of payment-shock blowups and foreclosures on today's interest-only deals multiply when borrowers take advantage of lenders' zero-down-payment, low credit score and high debt-to-income add-on features.
What does this all mean? Never focus solely on the upfront qualifying rate that gets you into the home. Ask yourself how and where you are going to come up with a 50 to 60 percent higher monthly payments three years from now.
If you don't have an answer, maybe interest-only isn't the game for you.
Kenneth R. Harney's e-mail address is firstname.lastname@example.org.