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Interest-Only Loans: Unnecessary Risk or the Path to the Future?
A recent issue that has surfaced in the past year is the discussion around interestonly loans. The major reasons for the sudden presence of this discussion are the
numerous reports circulating about how much market share these products are
commanding in the mortgage lending market. As a result of the typical economic data
lags, many economists have begun talking about the potential effects these loans could
have on consumers, the market, and the economy as a whole.
Interest-only loans first began being written in the 1920’s. After the depression in
the 1930’s, many of the loans that were foreclosed on were interest-only loans (Kass,
2006). Now in the next century, non-traditional, interest-only loans have increased from
6% of all loans written nationally in 2002 to 31% of all loans written in just the first two
months of 2005, according to Loan Performance of San Francisco, as reported in the 12th
Federal Reserve monthly newsletter. The percentage of interest-only loans has jumped
even higher in markets with particularly high priced real estate. For example, California
had an increase in interest-only loans from 8% of all loans written in 2002 to 61% of all
loans written in the first two months of 2005 (12th Fed Reserve, 2005). In the
Washington D.C area, 54.3% of home purchasers were using interest-only loans
(Downey, 2005). These percentages represent huge increases in what is termed as a nontraditional loan product. I will look at the pros and cons of why this is controversial in
today’s real estate market and why the federal regulatory agencies and the mortgage
industry are currently in debate.
Interest-only loans for the residential sector are mortgages that have a period of
time, normally 5, 10, or 15 years, where the homeowner only needs to pay the interest on
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the loan and no principal. There are several different variations of this loan concept.
Some interest-only mortgages have an adjustable interest rate for the entire life of the
loan while others have a fixed rate for a certain period of time which then becomes an
adjustable interest rate. In the past couple of years several banks have begun offering a
30 year, fixed rate, interest-only loan, which means the interest rate is set for the entire
life of the mortgage but principal payments are not required until a specified time. U.S.
Bancorp added this type of loan in September of 2005, and as a result, has seen this loan
increase to 8% of all new residential mortgages issued. The fixed rate, interest-only
mortgage has increased dramatically in popularity as interest rates have started to
increase and borrowers are adjusting to this change (Simon, 2006).
There are many other types of loans that are related to or are the result of the
interest-only loan, with several new loans stretching beyond the traditional 30 year
mortgage, to 40, 45 or even 50 years. Provident Bank Mortgage, in Riverside, California
began offering a 50 year loan as an option, mostly as a result of the increase in demand
for interest-only loans. Richard Hegg, the wholesale production manager, in responding
to the extremely competitive market for extending loan terms said, “In Japan, for
example, they have 100-year-term mortgage loans. We are getting closer to becoming a
global economy and we want to be the leader in this.” (Dymi, 2006) Another, somewhat
related version of the interest-only loan is a negative amortization loan. This loan
requires only part of the interest payment, with the rest of the interest charges being
added to the principal amount.
What is causing the dramatic increase in the use of interest-only loans? The main
reason for the increase is that interest-only loans traditionally were used by investors in
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fast-appreciating housing markets to capitalize on the increasing sale prices. As housing
prices continued to increase, many families have started to use this as a way to purchase a
home in the appreciating housing markets. (Mitchell, 2006) Another reason is the low
personal savings rate we are facing in our economy. As stated in the Federal Reserve
Bank of San Francisco in their monthly economic letter, “In September of 2005, the
personal saving rate out of disposable income was negative for the fourth consecutive
month” (FRBSF, Economic Letter, 2005). This means people have expenditures greater
than their incomes. Because of the low personal savings rate people are trying to stretch
their earnings as far as possible, leading to the attractiveness of interest-only loans where
paying no principal can save hundreds of dollars per month.
Tax laws also make the interest deduction a vehicle for homeowners to use the
equity in their homes to pay for other things such as cars, credit card bills, or other
expenses. The interest deduction makes borrowing higher loan to value amounts
beneficial to many families (Pender, 2006).
The positive and negative aspects of interest only loans are numerous on each side
of the spectrum. The main positive attributes of an interest-only mortgage are the ability
to use the principal payments in another manner and that this type of mortgage allows a
homeowner to buy a home that they might not be able to currently afford with a
traditional mortgage. The strategy of using the principal payments in another manner has
a few different possibilities, as the homeowner could use the savings from not paying
principal to invest in something that has a higher return than paying off the loan. When
the loan begins full amortization the homeowner will be able to use the additional income
earned from the money to aid in making the principal payments. Individuals with
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fluctuating income, such as someone on a commission based salary, can benefit from the
flexibility to use the savings from a lower payment to pay for other necessary expenses
during slower income periods. Many industry professionals note that the interest-only
option is great for a young professional who may have a lower salary now but in five
years will have a higher income. They can purchase the house now and meet the monthly
payments now and in the future. As one borrower notes, “In the beginning stages, when
you purchase a home, you have a lot of expenses, ‘the interest-only feature’ allows you
some flexibility” (Simon, 2006). The Clearing House, a mortgage industry group, cites
that borrowers benefit from an interest-only loan during the initial seven years of a
mortgage when there is little or no principal paid on any mortgage (Neubert, 2006).
The interest-only option is very attractive in real-estate markets with escalating
prices because for some potential homeowners this type of loan could be the only way to
secure housing. In light of hot real-estate markets, the interest only loan can be a great
option for someone who doesn’t think they will be living in their house for many years.
The advantage to using an interest-only loan is when the homeowner sells the house they
will be able to take advantage of any capital gains and may have been able to live in a
house they normally wouldn’t have been able to afford. As GMAC Mortgage noted, “…
first-time home buyers have been the biggest customers for this product” (Simon, 2006).
Essentially this could be, as one writer noted, “a practical way up the property ladder –
but only if you know all the risks” (Foley, 2006).
The major negative aspects of the interest-only loan revolve around the risk and
management of the loan. One problem that is most commonly reported is that many
potential borrowers don’t balance the lure of low payments they can afford now with
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larger future payments that they cannot afford long-term. An example given by one
writer, Jon Gin of the Times-Picayune, follows. “Once the ‘interest-only’ part of the loan
expires, say in five or 10 years, your mortgage payments can shoot up significantly,
hundreds or even thousands of dollars more each month” (Gin 2005). The increase in
mortgage payments is the result of the principal payments being re-amortized over the
time left on the loan and added to the required monthly payment. (Mitchell, 2006) These
values can be drastically increased if the interest-only loan also has an adjustable interest
rate. If the rate increases during the full amortization phase, the payment will also
increase. The payment shock that results when homeowners are not prepared for the
increase in payments can hamper other financial goals, such as retirement and
educational savings, even forcing some into bankruptcy (Gin, 2006).
Another negative is the delay in building of equity in the home. One of the major
benefits of homeownership is the equity that is gained by making payments to the
principal amount. When the house is sold the equity is returned. The argument is that if
you are not going to stay in a home very long and the market is strong, the equity will be
returned, even if you never make any principal payments. The opposite side of that,
which is the most concerning for economists now, is the scenario where the value of the
house stagnates or even begins to decline. The homeowners may have a loan on which
they owe more then what the house is worth. In many cases this scenario would result in
either bankruptcy or foreclosure, since few people could afford to pay the difference
between the loan value and lower sale price. An example of this can be seen in certain
markets that peaked in late 1989. When the homeowners sold their homes in the mid-
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1990’s their mortgages were higher than the value of their houses and they owned the
bank money (Kass, 2006).
In support of the positive argument that many people don’t stay in a home long
enough to reach the full payment requirements, Elinda Kiss, a professor at the University
of Mayland, notes that on average people move every five to seven years, making the
interest-only loan an attractive option (Mook, 2005). Although this may be true in many
situations, the proposition has several risks involved, such as changes in job and family
situations that would result in the family being required to stay in their current home
without plans of how to meet the mortgage payment. This would be particularly true for
those people who currently struggle to afford the initial interest-only payments (Mitchell,
2006).
Another negative of the interest-only loan is that they typically carry a quarter to a
half of a percentage point higher interest rate. If the loan being taken out is large, even a
small difference in interest rates can have a large impact on the overall cost of the loan
(Gin, 2006).
I personally saw an example of interest-only loans being marketed aggressively
when I toured my cousin’s house that he was building for resale in January 2005. The
realtor had literature in the house that said, “Buy this house for $1100 per month” (Home
for Sale, 2005). (I don’t remember the figures exactly but these are close
approximations.) The value of the house was roughly $380,000, and this low of a
payment for the approximate value made me curious. On the very bottom, in fine print, it
stated that the loan was an interest-only loan with several specifics. They were marketing
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the property to be very affordable without having the actual price of the house written
anywhere on the literature they were dispersing.
In October of 2005, the Department of the Treasury, Federal Reserve System, and
Federal Deposit Insurance Corporation (FDIC), began a comment period information and
data on non-traditional mortgage products including loans such as interest only
mortgages. “These agencies were reviewing the rapid growth in mortgages and were
particularly interested in loans that permit negative amortization, do not amortize at all,
or have a loan to value greater than 100 percent. Their goal was to seek comment if these
products should be treated in the same matrix as traditional mortgages or whether such
products pose unique and perhaps greater risks that warrant a higher risk-base capital
requirement” (FRBSF, December 2005). In essence, they were seeking comment to
know if banks should be required to hold a higher amount of reserves to cover the
perceived increase in risk, if there truly is more risk. In the docket sent to member banks
in the 12th Federal Reserve district it was stated, “They (the agencies listed above) are
also concerned that these products and practices are being offered to a wider spectrum of
borrowers, including subprime borrowers and other who may not otherwise qualify for
more traditional mortgage loans or who may not fully understand the associated risk of
nontraditional mortgages” (Fed Letter, 2005). The drastic increase in the number of
loans had many groups suspicious that more average homeowners were using these
products rather then investors who have higher tolerances for risk.
The major reason that the agencies above are issuing a warning is two-fold. First,
they are worried about the effect it has on the individual borrower. The risk that these
borrowers are taking is important to consider. As noted by the National Consumer Law
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Center (NCLC), a consumer advocacy group, “The huge –and continuing –escalation of
home mortgage foreclosures is inflicting devastating havoc on individuals, families and
communities” (NCLC, 2006). They went on to advocate that it is the responsibility of the
federal financial regulators to identify and decrease these foreclosures. From their
prospective, the regulators should not only be worrying about protecting the risk carried
by the lenders, but also the risk carried by the consumers (NCLC, 2006).
The other reason for the issuance of warning and guidance is for the potential
effect that the interest-only loan trend could have on the economy. At the local level the
NCLC argues each foreclosure has an effect on the local housing market. They quote the
following statistic: “… from FHA foreclosures in Minneapolis, (the) estimated average
city costs due to one foreclosure is $27,000, and neighborhood costs of $10,000” (NCLC,
2006). Even if the proliferation of non-traditional loans doesn’t result in foreclosures,
many economists are worried it could still affect the economy as borrowers, struggling to
meet required mortgage payments, will limit discretionary purchases. Tucker Adams,
chief Rocky Mountain-region economist for U.S. Bank stated, “It would be a drag on the
economy, but won’t cause a recession. It just adds to the threat of a recession and makes
it more likely to happen” (Heilman, 2005). The President of the Federal Reserve Bank of
San Francisco, Janet L. Yellen, was less concerned about the potential effects of these
riskier loans. Yellen stated in a speech to a Portland leaders group, “I believe the odds of
widespread financial disruption of this count (riskier loans) are fairly slim, although
clearly, some borrowers are vulnerable” (Yellen, 2006). She went on to say that the rise
of these products appeared relatively modest overall and that home valuations have risen
faster than mortgage debt. Also she noted that some of the risk associated with
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mortgages, traditionally held by banks, have been transferred to investors through
mortgage backed securities. She felt that these investors are in better shape to handle the
risk (Yellen, 2005).
The agencies gave the following guidance: “…lenders should qualify borrowers at
the current fully indexed interest rate and calculate the monthly payment as if the loan is
fully amortizing. A borrower seeking an interest-only loan should be able to qualify as if
they are making principal payments on day one.” (Collins, 2006) The mortgage industry
groups were very upset with the proposed regulations. The America’s Community
Bankers group felt that “restrictions on regulated financial institutions would do nothing
to control the practices of non-regulated entities” (Collins, 2006). This group also
believes that the risk is being over-exaggerated and regulating these non-traditional
mortgage products will greatly reduce their availability in the market (Collins, 2006).
The argument from the regulated banks is to encourage the agencies to modify the Truth
in Lending Act, Regulation Z, and the Real Estate Settlement Procedure Act. By
changing these acts, the guidance from the federal regulators would span across any
lender, not just the federally regulated institutions. The industry groups were also
concerned about these guidelines being applied to high net worth individuals, which the
industry groups feel are more financially sophisticated and are better able to assess the
risk (Neubert, 2006).
Many analysts figured that a cooling housing market combined with an increase
in interest rates would cause an increase in mortgage foreclosures, resulting in bank
losses. The losses haven’t occurred yet, but beginning in the last quarter of 2005,
delinquency rates have begun increasing. Analysts are very worried by the fact that
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many banks are still loaning with high risk loans. Alan Greenspan warned lenders about
enticing borrowers to take on more debt and “offer(ing) loans that have high percentage
of home valuations” (Der Hovanesian, 2006). Another concerning fact for borrowers is
that interest will rise in 2006 and 2007 on $1.3 trillion of adjustable-rate loans. These
changes in payment terms can be very troubling for borrowers who are not prepared. If
banks start to have several borrowers in default it could cause financial hardship for the
bank as well (Der Hovanesian, 2006).
In an attempt to mitigate some of the risk of these loans, several companies have
started educational programs to teach borrowers the difference between the terms of the
various loans. These companies are also trying to explain the significance of preparing
for the increase in monthly payments. Many lenders have stopped actively promoting
interest-only mortgages. In Mitchell’s 2006 article, entitled “Interest-only loans: Be
wary,” one mortgage officer said, “I’m really conservative, if someone says they
absolutely understand it and really want it (interest-only loan), I’d do it, but I wouldn’t go
out of my way to do one of these loans.” In the same Mitchell article another mortgage
officer was quoted as saying, “I am not a fan of them (interest-only loans). Only a very
small percentage of people who take out these loans really understand them. People are
just looking at the initial monthly payments. The best thing we can do is educate them.
But if they decide to take out one of these loans, it’s their choice” (2006). This is
basically what the Federal regulatory agencies are trying to do by educating people and
preventing those who can not qualify for the loan without financial hardship from taking
these types of loans.
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The literature and opinions surrounding this debate over non-traditional
mortgages has just begun. With the regulatory agencies still defining their goals for the
proposed guidance, the banks are waiting and preparing. The ultimate goal of this
guidance is to protect consumers and the economy. Many analysts suspect, as I noted
above, that the changes in interest rates, combined with a cooling off period for housing
prices, will begin to have an affect on the market for these products. As the media
continues to cover the positives and negatives of these mortgage products, and people
with adjustable rate interest-only loans begin to run into financial hardship, the appeal of
the loan programs are bound to either increase or decrease. The other direction this
debate could take is in defining the reality for this country’s economic future, where
housing prices continue to rise and the savings rate continues to decline. For many
people this could be their only option for purchasing a home.
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Case Questions:
1. Is it socially responsible to aggressively market a risky loan product, such as an
interest-only loan, to a financially uneducated consumer?
2. What responsibility do lenders have in educating their clients in all the potential
risks associated with the various lending options?
3. Should the consumer be held completely responsible for their financial decisions
or do lenders have an obligation to offer the most appropriate products?
4. Should first-time homeowners be a target for this type of product?
5. Are lenders responsible for ensuring all the documentation they receive is
accurate and thorough enough to make a decision?
6. Many non-regulated entities aggressively sell these riskier loan products to
consumers. Is it socially responsible to use this argument to lobby against
regulation?
7. Is it responsible for lenders to borrow loan amounts that reach the limit of loan to
value, which leaves a homeowner in a precarious position if home values drop?
8. Do lenders have any responsibility to the greater economy, in light of the fact that
offering risky loans can cause a drag on the overall economy?
9. Should lenders and consumers act more responsibly in pushing up housing prices
rather than offering and borrowing more risky products that push the limits of
loan to value?
10. Do lenders and borrowers have responsibility to be completely truthful and
conservative in their lending and borrowing when they know that the loan will be
sold on the market?
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References
12th Federal Reserve District. “Real Estate Lending Risks Monitor”. Monthly newsletter,
October 2005.
Blanchette, Aimee. 2006. “A farewell to ARMs?: As short-term interest rates rise,
adjustable-rate mortgages no longer are the home buyers’ darlings. Fixed rates are
making a comeback”. Star Tribune (Minneapolis, MN). January 21, p 1H.
Budworth, David. (2006). Warning over never-ending mortgages. London: Sunday Times
(London). March 19.
Collins, Brian. 2006. “Industry groups slam regulatory stance on ‘Exotic’ home loans”
National Mortgage News April 3, Vol. 30 Issue 26, p.3.
Curtis, Christopher T. 2006. “Comment on Proposed Guidance – Interagency Guidance
on Nontraditional Mortgage products.” Capital One Financial, March 29. Accessed
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draws government scrutiny” The Washington Post December 21, D01.
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Esswein, Pat Mertz, 2006. “Mild mortgage migraine” Kiplinger’s Personal Finance
June, Vol. 60 Issue 6, p22.
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balloon later” Times-Picayune, New Orleans, January 31, p. 1.
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Originations, Repayments, and Debt on One-to-Four-Family Residences.” Federal
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Heilman, Wayne 2005. “Interest-only mortgages on the rise in El Paso County, Colo.”
The Gazette (Colorado Springs) November 7.
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Howley, Kathleen M. 2005. “Many turning to interest-only loans; Mortgages allow
buyers to acquire high-cost homes, but at greater risk” The Houston Chronicle
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Mitchell, Lesley. 2006 “Interest-only loans: Be wary; If you're savvy, OK, but most Utah
families should stay away” The Salt Lake Tribune January 22, p. E1.
Mook, Ben 2005. “Risk said to rise with popularity of interest-only mortgages” The
Daily Record (Baltimore, MD) October 28.
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Nontraditional Mortgage products.” The Clearing House, March 28. Accessed via
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Wall Street Journal April 19.
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