It seems like everyone is getting the same message from mortgage lenders these days: Pay less for your home loan.
It’s a good message – if you know what you’re currently paying and understand what you’re being offered.
Most lenders want you to refinance and believe they can lower the interest rate you’re paying. Perhaps that’s true. If you had bad credit and have spent years paying down a 10 percent loan, you might be able to refinance if you’ve improved your credit. Or, if you financed your home and got an 8 percent rate on your loan, now you might be able to do better.
If your time frame has changed, you may be able to switch from a 30-year fixed rate mortgage to a 5/1 adjustable rate mortgage, which could substantially lower your interest rate.
But in the past year, a new kind of loan has been introduced to the mass market that confuses several issues. With interest-only mortgages, you pay only the interest. Every monthly payment is 100 percent interest. On the other hand, you never build up any equity in your home, unless your home appreciates in value.
Interest-only loans typically carry a variable rate of interest, for at least part of the time. Some of these loans are tied to the London InterBank Offered Rate (known as LIBOR), which adjusts every six months. Other interest-only loans carry rates that adjust monthly.
On a conventional adjustable rate mortgage, the interest rate cannot adjust upward more than 1 or 2 percentage points per year. These mortgages have a lifetime interest rate cap of 5 to 6 percent. But interest-only mortgages are a different breed. One interest-only mortgage started at 3.75 percent and is capped at 12 percent. The rate adjusts monthly.
At some point during a typical 30-year term, the interest-only portion of the loan ends. For homeowner who are unprepared, paying equity on top of the interest can be a real shock to the wallet.
Payments can jump by $500 or more per month, on a $150,000 mortgage, even if the interest rate doesn’t move, according to figures provided by HSH Associates, a financial publisher in Butler, N.J. (www.HSH.com).
But why think about the future when the interest-only period will last 10 to 15 years? Clearly, it’s the upfront cost savings that’s wooing customers nationwide.
"Interest-only mortgages are currently being presented to consumers as a way to buy more home for the money," explains Keith Gumbinger, HSH Spokesperson. “In reality, this is probably the most dangerous method of marketing these products, (because) you’re encouraging people to stretch themselves to the limit.”
While it’s true that borrowers can purchase homes they might otherwise not have qualified for, notes Gumbinger, there is no free lunch. Because the costs of selling a home can exceed 7 percent, you could end up owing money to your lender at the closing if the price of your home falls below the amount of your mortgage. When you’re not adding to your equity each month, the odds of that are more likely, he adds.
Here’s how the numbers work: Instead of paying $1,000 per month, on a $150,000 mortgage with a 7 percent, 30-year conventional loan, you’d pay just $695 per month during the interest-only period of a 30-year, “interest-only” loan. (Most home buyers don’t understand that the interest-only period on these loans is just 10 or 15 years out of a 30-year loan.)
Of course, you could take your $305 per month savings and use that to prepay your home loan. That’s the concept many savvy homeowners employ when they choose a 5/1 ARM over a 30-year conventional rate mortgage. They save on the interest rate and use those savings to prepay the principal.
According to The Banker’s Secret, a software program written by financial authors Marc Eisenson and Nancy Castleman, if you added $305 to each $695 payment, you’d shave 13 years off of your 30-year mortgage, paying the loan off in just 17 years. You’d save $47,357 in interest.
But if people actually wanted to prepay the interest, they’d probably get 15-year fixed-rate loans, currently available at about a half point less than the conventional 30-year rate.
According to lenders like Washington Mutual and Wells Fargo, and secondary market leader Fannie Mae, which expects to purchase $2 billion worth of interest-only mortgages this year, it’s the lower cost of these mortgages is proving attractive to so many home buyers and homeowners.
After all, if you don’t spend an extra $305 per month building up equity in your home, you’ll have more money to pay down debt, or add to it.
Is there any instance in which you should choose an interest-only mortgage? If you know you’re moving in a year or so, and you can get an exceptionally low rate on an interest-only loan, and you have something important to do with the extra cash, then perhaps this is the loan for you.
But many homeowners use their home equity as a kind of a piggybank, providing a cushion against everything from college expenses to catastrophic illness coverage. If you don’t start to build up equity when you first own your home, this nest egg might not be as large as it should be – or may not be there at all – when you really need it.
In other words, don’t rob your financial future just so you can live in a bigger house today.