Buyer can pay interest only

Demand is growing for such mortgages

Lower payments, higher risks

Danger to borrower is becoming overextended

October 24, 2004|By Lorene Yue | Lorene Yue,CHICAGO TRIBUNE

Homebuyers who want lower mortgage payments and a higher-priced house are fueling the interest-only loan craze.

Such loans aren't new, but mortgage brokers and banks have noted stronger demand as attitudes toward home loans have changed.

An interest-only loan can help buy a more expensive home or give the buyer access to more disposable income, said Ernie Grue, vice president of Sandy Spring Bank in Columbia.

A borrower would pay $1,774.61 a month in principal and interest a month for a $300,000, 30-year fixed-rate loan at an interest rate of 5.875 percent. With an interest-only loan, the monthly payment would be $1,468.75, more than $300 less.

"There's good and bad with it, as you can imagine," said Steve DiMarco, director of marketing sales for Mid America Bank in suburban Chicago.

The borrower could become overextended if it's the only way he can afford to buy a home, DiMarco said.

If the loan is held long enough, the payment could swell because the interest-only option isn't indefinite.

Most lenders will provide an interest-only option for 10 years. After that, the loan amortizes for the remaining years, and the shorter amortization period means a higher payment if the principal remains the same. A $200,000 loan over 30 years would cost $1,199.10 a month at a fixed rate of 6 percent, compared with $1,432.86 a month over 20 years.

An interest-only loan is not advisable for everyone. Here are some advantages and disadvantages.

An interest-only loan could be the way to go for a buyer not planning to stay for long in the home.

Borrowers have held mortgages for less than seven years, said Doug Duncan, chief economist for the Mortgage Bankers Association. And in the initial years, most of the payment goes toward interest. With a $200,000, 30-year fixed mortgage at 6 percent, the payment is $11,933.19 in interest in the first year and $2,456.01 toward principal.

Interest-only mortgages might appeal if the borrower's income changes throughout the year because of bonuses and commissions. Just because interest is being paid doesn't mean payments on the principal can't be made. If the borrower got a $3,000 bonus one month, it can be directed toward the principal.

Opinions on building equity with an interest-only loan vary. If the home never increases in value, no equity will be built by paying off only the interest. And the buyer is underwater if the house depreciates, DiMarco said.

Although housing values have been increasing for many owners, they should be poised for slower growth. Prices have gone up about 6.4 percent this year for previously owned houses and 9.7 percent for new homes, Duncan said. Prices are expected to rise 3 percent to 4 percent next year.

The lender should understand what kind of loan he is getting (some have interest rates that adjust monthly) and how the payments might change. Some could add to the amount owed.

"Any time the interest rate adjusts at a different rate than the payment adjusts, then you could have negative amortization" if the total amount you've paid at the end of the year is less than the balance due, said Doug Perry, senior vice president at Countrywide Home Loans in Calabasas, Calif. In that case, the shortfall gets added to the loan amount.

Lorene Yue is a Your Money staff writer at the Chicago Tribune, a Tribune Publishing newspaper.

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