Interest Only Home Loans – Consumers Beware!

Real-estate prices around the country have been spiraling, thanks largely to low interest rates. Unfortunately, many panicked buyers have found that to get into the house or neighborhood that they want is simply unaffordable.

Here comes the lending industry to the rescue! (Uh… did I really just say that?) Well, not so fast.

Interest only loans were not invented yesterday. For speculators and short term investors, they can be the loan of choice; offering low down payments and manageable monthly payments.

Interest only loans are just what they say. You take out a loan and only make interest payments, paying nothing on principle. This reduces the amount you pay on a monthly basis. It also means that the amount of principle that is owed the lender doesn’t change. For those who only plan on holding onto a property for a short period of time, these loans offer a great deal of flexibility, and relatively little risk. If on the other hand you are purchasing your primary residence, you should avoid these loans for a variety of reasons.

When purchasing a home, buyers tend to look at how much they have to put down and how much their monthly payments will be. Many of the interest only loans on the market are available with low down and monthly payments.

Although interest only loans may seem attractive at first, those that are typically offered to home buyers have some significant downsides.

First of all, these loans actually convert to standard adjustable rate mortgages after a certain time period, usually 36 or 60 months (we’ll call this the initial loan period). During the initial loan period, the interest rate is fixed. This means that at the end of the initial loan period, you could be in for some real sticker shock.

Let’s say you take out one of these loans at a fixed rate of 5.25% for the first sixty months. Without any increase in interest rates, in month 61, your payment will increase by 25% because you now have to begin paying down the principle on your loan. If interest rates have jumped by 1.5% since you originally took out your loan, your payment in month 61 will jump by 50%. At a 2.5% increase, your payment in month 61 will be 64% higher than it was in month 60. And you still have 25 years left on the loan.

This is not the worst of it however. Because high real-estate prices have been driven by low interest rates, it stands to reason that as interest rates go up, there will be a downward push on housing prices. While this may not be true for all areas of the country, it will be true for most areas. This means that consumers that find themselves as the proud possessors of interest only loans could find that they have something else to panic about.

If the price of their house drops, consumers holding these loans could find that they have lost the value of any down payment that they did make, and that they owe more on the house they purchased than it is actually worth.

These loans, while tempting are also a recipe for personal financial disaster. As a rule of thumb, if you can’t afford a loan that includes both principle and interest payments, then you can’t afford the house. As a consumer, you will be far better served by either saving for a larger down payment, or purchasing a less expensive home. You may not get exactly what you want right now, but you won’t have to face the possibility of bankruptcy or foreclosure later.