What Hazards Should You Watch Out For

 

The major hazard is being deceived into accepting an interest-only mortgage that does not meet any of the suitability tests described above. The deceptions are about alleged desirable features of IOs that don’t exist.

Borrowers can immunize themselves against most deceptions by remembering one critical fact. If two mortgages are identical except that only one has an interest-only option, lenders view that one as riskier. The reason is that, after any period has elapsed, the loan with the IO option will have a larger balance.

Deception 1:
An interest-only loan carries a lower interest rate. Lenders usually charge a higher rate for an identical loan with an interest-only option, for reasons indicated above. I have never seen a price sheet in which a lender quotes a lower rate on an identical loan with an IO option, though I am told it happens; this is not a perfect market.

The deception arises from comparisons of apples and oranges. Most interest-only loans are adjustable rate mortgages (ARMs), and ARMs have lower rates than fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates than FRMs because they are ARMs, not because they are IO.

Deception 2
An interest-only loan allows the borrower to avoid paying for mortgage insurance. Since loans with an IO option are riskier to the lender, the option cannot cause the disappearance of mortgage insurance.

Any IO loans with down payments less than 20% that don’t carry mortgage insurance from a mortgage insurance company are being insured by the lender. The borrower is paying the premium in the interest rate rather than as an insurance premium.

Deception 3
On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. It may or may not be. The interest-only period is the period during which you are allowed to pay interest only, usually 5 or 10 years. The period for which the initial rate holds can be as long as 10 years or as short as one month.

Where the initial rate period is 3, 5, 7 or 10 years, the interest-only period is likely to be the same. Where the initial rate period is a month, 6 months or a year, the interest-only period will probably be longer. These are the cases where deception is most likely to arise.

Deception 4
It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.

There is no magic connected to amortizing an interest-only loan. A borrower who takes an interest-only option but decides to make the fully amortizing payment instead will amortize in exactly the same way as the borrower who takes the same mortgage without the option. Read Does an an Interest-Only Amortize Faster?

What Information Do You Need To Assess An IO Mortgage?
ARMs have the advantage of carrying a lower interest rate, and lower monthly payment, in the early years than fixed-rate mortgages (FRMs). But because the ARM rate is adjustable, it may rise in later years, and the payment will rise with it. Intelligent decisions about ARMs, therefore, require that account be taken of what might happen when the initial rate period ends.

While future interest rates are not known, we can make assumptions about what will happen to rates; these are called interest rate scenarios. Usually, we focus on rising rate scenarios, because those are the ones we worry about.

For any given scenario, we can calculate exactly how high the rate and mortgage payment will go, and when it will get there. This is scenario analysis. We can also calculate the total cost over any period specified by the borrower. In assessing ARMs with an IO option, borrowers will want to compare scenarios with and without the option.

When ARM rates are much lower than FRM rates, shrewd borrowers may take an ARM but make the payment that they would have had to make had they taken an FRM. By paying the balance down faster, the cost imposed by rising rates in the future is reduced. Hence, it is useful to perform scenario analysis based on the assumption that the borrower pays at the FRM rate for as long as that payment is larger than the ARM payment.

This is an alternative to an IO, and based on the opposite premise. Where an IO attempts to minimize the borrowers payments in the early years, for any of the reasons noted earlier, the FRM payment option is designed to pay down the balance as much as possible in the early years.

To see a sample of rates/payments and costs on an ARM, with and without both the interest-only and FRM payment options, click on Sample Rates/Payments and Costs.

 

 

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