Home Buyers Turning to Interest-Only Loans

A growing number of consumers are betting that home values will continue to appreciate as they take on mortgages that sharply lower their monthly payments but require them to shoulder far more risk.

Interest-only mortgages have surged, particularly in California, as prices spike and mortgage rates plunge. The loans, which once were aimed at a small pool of affluent borrowers, have gone mainstream.

At Washington Mutual Inc., the nation’s largest residential lender, such mortgages have accounted for roughly $1 billion a month since being introduced last summer. As mortgage rates fell to the lowest levels in decades, the loans were the most requested of all categories, said Gregory Sayegh, a senior vice president in the Irvine office.

“We’ve seen a dramatic shift over the past 30 days,” he said.

This type of mortgage, designed for buyers who intend to live in their homes for less than the length of the loan, allows borrowers to make lower payments than a traditional mortgage because none of the monthly payment goes toward the principal. Interest rates generally are up to 1 percentage point lower than fixed-rate mortgages, and the full payment is tax-deductible.

Typically, payments on a 30-year interest-only mortgage at 5.5% on a $500,000 home would be set at $2,292 a month, compared with a fixed loan at $2,839. That represents a monthly savings of $547.

After five years, when repayment of the interest-only mortgage typically converts to an adjustable rate for the last 25 years of the loan, the borrower could have saved about $33,000, which might be used to pay for a child’s education or to invest in other ways.

In a traditional mortgage, part of each payment is applied to the principal of the loan. Using the same example, a borrower after five years would have accumulated about $38,000 in equity, which also could be tapped for other uses through another loan.

“The question the consumer has to ask is: Am I further ahead [with an interest-only loan] rather than having the money sit in equity?” said Brad Blackwell, a senior vice president at Wells Fargo & Co.

No group tracks the use of the loans. But Blackwell said interest-only loans, though they make up only about 5% of overall volume at Wells Fargo, are rapidly gaining in popularity.

“What’s driving demand is that people are saying, ‘I don’t know if I’ll be in the house for three to seven years. Why pay a higher rate of interest to lock in a rate for 30 years when I know my circumstance will be changing?’ ” said Craig Cole, a senior vice president at Union Bank of California, where use of interest-only loans also has soared.

But the loans could leave borrowers worse off if home values should stop rising or decline. At the end of the interest-only period, generally five to 10 years, consumers could be left owing more than the home is worth.

Even if prices keep appreciating, analysts said, borrowers may need to refinance to more-favorable terms when the loan’s interest rate becomes adjustable.

Interest-only loans, which have been around for about a decade, generally appeal to wealthy buyers who need large loans to purchase expensive homes. Those borrowers usually know they plan to move into another home or to refinance before the loan is repaid.

The loans now are pitched to a broader audience as a way to buy more house for the money and to offset rising prices.

“No one is talking about the risks,” said Keith Gumbinger, an analyst at HSH Inc., a New Jersey firm that tracks the mortgage market.

“Markets do turn around and turn around uncomfortably, and not paying equity on a home means a borrower will still owe a lot of money down the road.”

But many borrowers have found an interest-only loan too good to pass up. A similar product based on the concept also is gaining considerable steam as a method to purchase homes. Borrowers pay only interest on a line of credit for 10 years that can be used like a checkbook to pay off the home or to make other purchases.

Blackwell said California accounts for about 40% of the national market at Wells Fargo for super-jumbo interest-only loans. With rates now in the mid-4% range for such loans, Blackwell predicted that the concept would draw “more and more people.”*

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Weigh the Risks Before Applying

Interest-only loans are suitable for some borrowers, but they’re not for everyone.

The loans are intended for those with top credit, a strong cash flow and a willingness to refinance or move when the interest-only period ends.

Before applying for such a loan, be sure to understand the risks:

* None of the monthly payment counts toward the actual cost of the home. At the end of the interest-only period, the borrower still owes the full amount of the original loan.

* If property values decline, the borrower could owe the lender more than the home is worth.

But such home loans have certain advantages:

* Monthly payments are smaller than in traditional mortgages. Some borrowers use the savings for other investments.

* The entire payment is tax deductible.