Home Basics
Are Interested-Only Loans Principally Risky
Sunday, June 19, 2005
Kathy Bushouse and Robyn A. Friedman
Sun-Sentinel
Increasingly their financing method is interest-only loans. For example, Robert Freeman of West Palm Beach, publisher of the monthly newspaper New Business Today, used these loans to buy condominiums and townhouses.
"Interest-only financing gives me more leverage," Freeman said. The holder of an interest-only mortgage pays less initially per month than someone who has a traditional mortgage.
The use of interest-only loans is exploding: Almost one-third of all U.S. home buyers last year chose this kind of financing. Lenders say such loans can help people buy bigger, more expensive homes. They also can make sense for investors who hold properties for short periods.
But some analysts and federal regulators warn that, if a suspected housing bubble bursts, such loans could help push homeowners into foreclosure and pose a risk to banks, which may not be able to recover their money.
"The biggest problem prior to all this money being available was getting a buyer qualified," said David Dweck, a real estate agent in Boca Raton. "Now, if you can fog a mirror, you can buy a $500,000 house."
Some say the structure of interest-only loans invites trouble. Homeowners typically pay off these loans over 30 years -- the same as with a conventional loan. But for a period of time -- often five years -- a borrower can choose to pay just the interest on the loan.
The problem: After that interest-only period ends, homeowners must start paying down the principal, along with the interest. The interest rate for such loans is usually not fixed, but rather adjusts according to market conditions. Couple that feature with a likely future increase in today's historically low interest rates, and buyers could find their monthly payments nearly doubling in a few years.
Federal Reserve Chairman Alan Greenspan expressed concern last week about interest-only loans in remarks to Congress' Joint Economic Committee.
"To be sure, these financing vehicles have their appropriate uses," Greenspan said in his prepared testimony. "But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace."
For example, the loans are seen as further inflating home prices. In Florida, housing prices rose 21.4 percent for the first quarter compared with last year. Prices have not cooled off, as some experts expected. Financing methods like interest-only loans are partly to blame, some say, because buyers can bid higher and afford more expensive houses.
The number of these loans has soared. In 2001, only 1.6 percent of homes sales nationwide were financed by interest-only loans, compared with 31 percent last year, according to figures from LoanPerformance, a San Francisco firm that compiles and tracks mortgage data.
In South Florida, 31.2 percent of home sales in the Fort Lauderdale metro area -- more than double the rate of the year before -- and 37.6 percent of home sales in the West Palm Beach/Boca Raton area were financed by interest-only loans.
Customer demand is driving banks to offer new and different mortgage products, from interest-only loans to granting borrowers 40 years rather than 30 to pay off their fixed-rate loans. The new products allow more people to qualify for loans.
Homeownership has reached a record of 69.1 percent in the first quarter of 2005, up from 64.2 percent for the same period in 1995, according to U.S. census data.
A product in demand
Between 15 percent and 20 percent of the mortgages issued by Fidelity Federal Bank & Trust are for interest-only products, said Ken Stone, senior vice president for retail residential lending. If you want to be competitive in the marketplace, he said, you have to be able to offer these loans.
The double-digit yearly gains in South Florida's median home prices play a big role in the new types of mortgages, said Les Grene, senior vice president for retail residential lending at Coral Gables-based BankUnited.
"Look at the price of homes now," Grene said. "It's almost dictating you find a way to find an avenue to get into something that's affordable."
About 95 percent of the business that Anthony Cutaia conducts at Cutaia Mortgage Group Inc. consists of mortgages with "interest-only components," he said. CEO Cutaia touts the benefits of these loans at seminars and on radio and television programs that he pays for and hosts."There is no advantage ever in making a principal payment on a mortgage," Cutaia said. He said a homeowner will make more money taking the amount that would have been used to pay down the loan principal and investing it.
In fact, he suggests that his clients set up a "mortgage savings account," an interest-bearing account where they deposit the difference between what their conventional payment would have been and their interest-only payment. By the end of five years, he says they will have come out better financially than if they had made principal payments.
But some regulators and analysts are concerned that homeowners won't be ready in five or so years when their interest-only bill balloons in size to include paying down the loan principal. If the monthly amount increases too much, homeowners won't be able to pay it and their house could wind up in foreclosure.
"They are financing lifestyles that they can't afford," said Howard Dvorkin, founder of the Sunrise-based Consolidated Credit Counseling Services.
Worsening the problem is the possibility that South Florida suffers from a real estate bubble -- a market with over-inflated values. Homeowners with interest-only loans don't build "equity," or ownership, in their homes if they're paying only the interest. If the real estate market slows and prices slip, that could be a problem.
"They're going to have nothing," Dvorkin said.
Hope and confusion
Some homeowners take out interest-only mortgages because they think the housing market will keep rising and they want to make sure they're getting in before homes become even less affordable, said Nicolas Retsinas, director of Harvard University's Joint Center for Housing Studies.
It appears "they're just desperate," Retsinas said. "My guess is people are perhaps thinking, `I'm sure in a year my salary will go up. I'm sure in a year this will appreciate so much that if I can't make the payments I'll be able to sell it.'"
People also may be thinking only about their monthly mortgage payment, and paying little heed to the other costs associated with homeownership, such as insurance or property taxes or maintenance, he said.
Another problem with these loans: Borrowers may not understand what they're getting into, said Keith Gumbinger, vice president of HSH Associates, a financial publisher in Pompton Plains, N.J.
Gumbinger said he has corresponded by e-mail with people who took out interest-only loans and "did not truly understand the product."
"We are increasingly selling mortgages on the ability of the borrower to make the monthly payment, at least today," he said.
For their part, lenders say interest-only loans aren't for everyone. But they think that today's borrowers are savvier and more knowledgeable about the risk they're assuming, thanks to the Internet and other available research that lets people compare rates and products before buying.
"Your consumer today is so much more educated than he's ever been," said Fidelity Federal's Stone. "All of that has combined to creating all these programs."
Now banks had better hope that homeowners are smart enough to keep the roof over their head if home prices fall through the floor.
