When Lawrence Ragland was looking to expand his real estate holdings, he used funds he obtained from a cash-out option on a five-year interest-only loan. Interest-only loans allow buyers to lower their mortgage payments by paying the interest on the loan for a period of three, five, seven, or 10 years. At the end of that period, the mortgage payment is increased to include both the principal and interest portions of the loan. The new payment amount is typically higher because now there is less time to pay off the loan’s full, amortized amount.
Ragland, a 62-year-old certified public accountant from Crete, Illinois, lowered the initial payments on his $190,000 four-bedroom home, but his strategy won’t work for everyone.
That is what makes these loans risky. Some people mistakenly take interest-only loans because of the lure of the initial lower payments. “People are looking at the initial payment, and that’s already as much as they can afford,” says Jef Kinney, vice president for innovation development at Fannie Mae. Once the interest-only term ends, the monthly payment will increase, leaving borrowers only 20 to 25 years to pay off the mortgage instead of the standard 30. The increased payment will cause a problem for those on fixed or lower incomes. As Kinney points out, “Moving or refinancing isn’t always as easy as people think.” If your credit score has gone down since the time you received the initial loan, refinancing might not be a viable option.
Pierre Dunagan, president of The Dunagan Group in Chicago, agrees. Dunagan notes that if the value of the homeowners’ property doesn’t appreciate much over the first three to five years, it may be difficult to get a better loan. In today’s housing market, rapid appreciation isn’t likely. “If you’re planning on retiring in that house or paying it off, then an interest-only loan isn’t for you,” says Dunagan.
In December of 2002, Ragland took out a $300,000 adjustable- rate loan on his home, refinancing the $190,000 he owed from his initial interest-only loan. He used $100,000 to purchase two, two-family dwellings. “One of the things that attracted me to this type of loan was the 50% drop in my interest rate,” he says. “It went from the original 7.5% to 3.85%.”
More than 24% of all mortgage loans approved in 2004 were interest-only — up from 10.4% in 2003, according to LoanPerformance.com. Interest-only loans have been increasing, but borrowers should understand how to use them properly. “These loans originally targeted the financially sophisticated borrower, someone who wanted to use their mortgage as part of their overall [financial] management plan,” explains Kinney. Individuals looking to free up cash for investment possibilities can benefit, as long as they are prepared to sell the home, or refinance, before the interest-only period ends.
Interest-only loans also attract entrepreneurs and individuals who work on commission, says Dunagan. Individuals without steady paychecks — such as salespeople, whose incomes vary with their performance — find the lower monthly payment affordable. “In the better months, they can pay more toward the