, Interest Only Mortgage Loans May Come Back To Haunt Homeowners

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Offered An Interest Only Home Loan? There May Be More To It Than Meets The Eye!

Housing markets across America have been booming for quit some time now, yet people are still rushing to get on the property investment bandwagon for fear of being left behind. In this clamor for closings, many of these Johnnie-come-late-lies are allowing themselves to be blinded by reason and they are accepting mortgage terms that could one day come back to haunt them.

In the last two weeks alone, we have heard a lot of talk and speculation about a housing bubble and "frothy" markets, as Alan Greenspan of the Fed has termed it. Consequently, it's no wonder that many believe that the housing boom is about to go bust. Despite all of this talk and reasoned analysis, many people who felt they were left on the sidelines during the dot-com boom of the late 1980's, are doing all that they can to acquire bigger and more costly properties. In 2004 the state of California, which is not a newcomer to boom and bust scenarios by any means, had the unique distinction of having five cities within that sate in the top ten nationally for home buyers opting into interest-only mortgages. 2005 has shown an even greater demand. Two out of every three San Francisco home purchases are now being financed by interest-only loans, and Marin, San Mateo and San Jose are right on their heels. Nationally, a third of all loans granted last year were interest-only mortgages. It's no wonder that we may soon see a crisis.

Just exactly what is an interest-only home loan, and what are the downsides?

Well, it really isn't interest only, at least not for the full term anyway. For the first three, five, or even ten years, a borrower will only pay the interest on the loan and the principal is "neglected". After the initial period has expired, the original principal payments will then kick in and be amortized over the remaining term of the loan. Because these borrowers are repaying the principal in fifteen to twenty five years time (relative to their original amortization terms), those principal payments are higher than they would have been. Further understand, that if this interest-only loan is part of a hybrid Adjustable Rate Mortgage, then the interest rate will have also been fluctuating during this time.

Interest-only borrowers need to recognize that once the honeymoon period is over, their payments most often will immediately leap into a much higher bracket. If they had chosen to borrow in a more conventional fashion, payments would have remained constant and they would have also built up considerable equity.

Here is an example of the equity they could have established and would now be available to them through a HELOC (Home Equity Line of Credit):

Amount borrowed: $375,000

Interest rate: 6.25%

Term: 30 years

Equity after 5 years: $24,985

Equity after 10 years: $48,338

Needless to say, these loans are not for everyone. If someone is in a fixed income job, and can't foresee an increase in their earnings, they should think more than twice about these terms, because when the housing bubble bursts, and prices begin to fall or stagnate, they could end up owing much more than their home is actually worth. This is known as "negative amortization," and most people do not fully understand its ramifications. The entire balance of the loan (the principal that was "neglected" before), must now be added to the interest on the loan and be paid off over a shorter period of time. The payments in the second part, can often be two or even three times what they previously were. This could turn that idyllic little house on the prairie into an Amityville horror sequel.

What could be good about interest-only mortgages?

Well to start, the payments per month are lower, sometimes considerably, but that depends on the size of the loan itself. People can now afford to stop renting and move into homes that would have previously been out of their budget range. Homeowners can also pay down the principal when they choose, most often without a penalty.

Tax savings are also a benefit derived from interest-only terms while the principal is not being paid down, because a mortgage's interest is still a deductible expense for most tax filers. For people who are self-employed or work at seasonal jobs, and have fluctuations in their income, this is also a reason for interest-only mortgage s to be an attractive alternative. When they are in lucrative times, they can make payments towards the principal. If their gamble is a good one and values do go up, they will see an increase in equity/value when they do sell, thus coming out ahead.

If you are contemplating an interest only mortgage, please assess the pros and cons. For more information on interest only mortgages and interest rates, visit

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David Levine