Are Interest-Only, Option ARMs, and Other “Exotic” Loans Really Any Riskier Than Fixed Rate Loans?

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Are interest-only and ARM loan programs being fairly treated? Could it be that homeowners and loan officers are really the ones to blame?

The National Association or Realtors (NAR) and other organizations have issued warnings against these types of loans. It is true that many consumers have misused them and that many mortgage brokers have sold homeowners these types of loans that really shouldn’t be using them. But are they just getting a bad reputation because of the lack of understanding about how they should be used?

“When used properly, Interest-Only and Option ARM loan products can be extremely beneficial for the homeowner. I cannot over emphasize the importance of planning when using these loan programs,” says Robert D. Ashby, a Certified Mortgage Planning Specialist and President of Solid Rock Mortgage Corporation. Mr. Ashby adds, “No one should be using these loans to qualify for a house they would not be able to otherwise afford.”

The reason these loans are being portrayed as “risky” is due to misuse of these loans by homeowners and mortgage professionals alike. These types of loans are designed more for homeowners that have the discipline to follow through with a professionally designed mortgage plan, just like a family’s financial plan.

Most arguments against these loans do not factor in the benefits of these loans, and instead focus on risks. One recent example was weighing in on interest-only loans, stating that it would cost the homeowner more over five years. This is typical thinking of those against these mortgages. The truth is that when used properly, the homeowner would use the difference in payments to yield at least the same rate of return, and in reality would be better off.

The argument assumes the same interest rate on both loans and shows that the difference in payment between an amortized loan and interest-only at 6.375% would be $185.24 per month. This results in the amortized loan costing $11,114.40 more over five years. However, due to the principal reduction of $13,049.51, there is a savings of $1,935.11. When you look at this way, it cost the homeowner more to have the interest-only mortgage.

Since FNMA shows the average length of a loan is 4.2 years and the argument is based on five years, a more realistic comparison would use the 30 year fixed rate for the amortizing loan and a 5/1 ARM for the interest-only loan. When the homeowner is disciplined enough to invest the difference monthly (same monthly expenditure) the picture changes dramatically.

Using this loan comparison, the payment difference would be increased to $226.91 since the 5/1 ARM is only 6.125% while the amortized loan’s 30 year rate is 6.375%. As mentioned before, the interest-only homeowner invests the difference into a conservative side account with a 6% rate of return. While the amortized loan’s principal grows to $13,049.51, the interest-only homeowner’s side account grows to $15,831.52 providing a $2,782.01 savings.

What’s amazing is the interest-only homeowner has the ability to obtain increased rates of return and improves liquidity, which is vital in a financial crisis. As you can see, the disciplined homeowner will come out ahead when using the interest-only option and investing the difference.

So now we know the homeowner can be better off with interest-only loans when used properly. What about Option ARMs? Some mortgage brokers sell the Option ARM products without explaining the risks simply because they can make more money on them. Don’t get me wrong, Option ARMs can play a significant role for a homeowner, but again, the homeowner needs to have a mortgage plan and be disciplined to follow through.

If the homeowner has a lot of credit card debt and needs a lower mortgage payment, for instance, these programs can offer the ability to pay down that credit card debt by lowering the monthly payments. They are also a fairly good product if the homeowner needs to increase their liquidity fast and cannot afford to take cash out during their refinance.

“The problem with Option ARMs is that many Americans do not use this product correctly. They tend to consume the savings available with this product, thus costing them enormous amounts of money and potentially leading them to foreclosure,” Mr. Ashby comments. He continues, “I only like Option ARM products when the homeowner understands the risks and has the discipline to use the savings wisely. Most often these products have a 3 year prepayment penalty leaving the homeowner locked into the loan or face a hefty ‘fine’.”

Option ARMs are usually adjustable on a monthly basis. The risk here is minimized by using indexes that do not change dramatically monthly, but can change significantly from the time the loan was originated. Also, these loans can be “recast” when the principal balance reaches a predetermined value, resulting in an immediate payment increase that the homeowner may not be prepared for. This is a likely scenario for those who took out this loan fairly recently as the indexed rates have risen and the minimum payment was based on a 1% rate.

In summary, the interest-only and other “exotic” loan products may be better for the homeowner, when used properly. They are getting a bad reputation because many homeowners and mortgage professionals have used them improperly, making them more costly. The bottom line is a mortgage is a financial tool and cannot be taken lightly. You wouldn’t go to an optometrist to get heart surgery, so you should seek a Certified Mortgage Planning Specialist when preparing your home purchase or refinance.

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