Thursday, June 30, 2005

Coming to terms with interest only Mortgages

This is one of the best explanations of the effects of high leverage mortgages.

The question is, what will happen over time when housing prices ease off and people are left owing more on their house than it is worth.


Personal finance: Interest-only loans no bargain

Jeff Brown
PERSONAL FINANCE

Many people are flocking to interest-only mortgages. One Philadelphia lender said these made up half the mortgages it had written in the past six months.

Lenders have been reporting similar figures nationwide.

Let me cut to the chase: Stay away from these things! They're not interest-only mortgages, they're extra-interest mortgages that can increase your costs, not cut them, as the ads promise.

Interest-only loans allow people to borrow more than they can with ordinary loans because the monthly payment does not include any money to pay down principal - the money that was borrowed. The soaring popularity of these loans is evidence borrowers are pushing to the limit, taking on big risks to buy more home than they really can afford, or to pick up second or third properties.

It's more evidence of a housing bubble that could leave millions of Americans owing more on their homes than the properties are worth. Interest-only debt assumes housing prices will continue to go up, but they might not.

To see how these loans work and why they're so bad, let's first look at a conventional 30-year, fixed-rate mortgage.

Today, these loans charge about 5.75 percent, but let's say 6 percent to make it easy. For every $100,000 you borrow, you'd pay about $600 a month. That's composed of two parts. At the start, you'd pay $500 in interest, $100 in principal.

Over time, the principal payments chip away at the debt. As the debt gets smaller, the interest payments drop, too. That's because they're figured each month by applying the interest rate to the remaining debt.

Since the monthly payment is always $600, a smaller portion goes to interest each succeeding month and a larger portion to principal. The effect snowballs. At the start of the mortgage's last year, when only $6,400 of principal is left, just $35 a month goes to interest, $565 to principal.

Now let's look at an interest-only loan for the same amount. Typically, there are no principal payments for the first five, seven or 10 years. The monthly payment during this period is therefore $500, compared to the $600 on the standard loan. Instead of enjoying this lower payment, many borrowers simply take out bigger loans.

What's so bad about all this?

The piper has to be paid eventually. After 10 years, for example, the principal payments would start. Now the $100,000 has to be paid off over just 20 years, instead of 30. So the monthly principal payments have to be bigger than they'd be with the standard mortgage. And, since the principal has not been trimmed, the interest payments are larger, as well.

Result: The monthly payment jumps from $600 to $716. Total interest over the 30 years would be $127,600 instead of $116,000 with the ordinary loan.

But wait, it gets worse. Most of these loans carry rates that are fixed only during the interest-only period. After that, they typically adjust annually as prevailing rates rise and fall.

Imagine if rates in 10 years are 8 percent, a typical level, historically. In this case, our borrower would pay $156,376 in interest over the loan's life, 35 percent more than with the conventional mortgage.

These days, fixed-rate loans are bargains. Don't gamble your future with a risky interest-only deal.

Jeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at brownj@phillynews.com.

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4:10 PM  

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