Lenders using interest-only mortgages to spur business

by Denise Trowbridge, New Orleans CityBusiness, November 2004

Rick Crozier, vice president of Hibernia National Bank Mortgage Banking, has had plenty of loan applications to process lately thanks to the lowest interest rates in more than 40 years. Refinancing drove the surge, accounting for 80 percent of Crozier's business the last two years.

But, according to Hibernia's third-quarter financial statements, income from mortgage lending is down 80 percent from the same time a year ago.Now that the "refi" bubble has burst, Crozier and other mortgage lenders are looking for ways to extend the prosperity.

"Twenty five percent of the real estate boom around the country is new construction," Crozier said. "New Orleans proper doesn't benefit from this because land is at a shortage. But what is driving our loans, and the rest of the real estate boom, is higher prices and home values."

Crozier says New Orleans home values have risen 7.5 percent each of the last four years. This led to mortgage professionals offering new products in order to resurrect the lending boom.

One new twist on the traditional adjustable rate loan is the interest-only mortgage, which allows borrowers to pay only interest and no principal for a set length of time, usually between 5 and 10 years. At the end of the term, the borrower can either refinance the loan or begin repaying the principal.

The initial savings appeal to many borrowers. “The monthly payment can be up to 25 % lower than a regular mortgage,” Crozier said. Because the loan is tied to an adjustable rate mortgage, the initial interest rate is very low, sometimes as little as 3%. On a $300,000 loan, the monthly payment would be $800, versus $1800 on a traditional 30-year fixed rate loan at 6%.

“And 100% of your payment can be tax deductible,” Crozier said. “You can write it off and then invest the money you would have spent on the principal in a higher yielding investment.”

The loan also gives borrowers flexibility; they can pay only the interest when they need to and pay down the principal when they can, said
O. Bruce Coffman, the president of Mortgage Market Inc. in Metairie and president-elect of the Louisiana Mortgage Lenders Association.

Mortgage lenders benefit from interest only loans as well. They can maintain the volume of new loans even as interest rates and property values rise because these loans “make homeownership open to more people,” Coffman said. “It's easier to qualify for an interest-only loan than a fixed rate because the payments are so much lower.”

Lenders are also guaranteed a decent return. “Banks love them because of the floating interest rate,” Crozier said. “Banks hate fixed rate loans because they lose out when interest rates go up, but with adjustable rate loans, they make the money they need no matter what the market does.”

And since many interest only mortgages have no rate cap, there is no limit to how high the interest rate can go.

But as appealing as they may appear, “interest only loans are not for the faint of heart,” said Coffman. For borrowers, there is a potential double-whammy at the end of the term, when principal payments combined with higher interest rates can substantially increase the monthly payment. The rate on an interest only mortgage can begin to fluctuate in as early as one month, depending on the terms. “[The borrower] is riding the tiger with any adjustable rate mortgage,” Said Coffman. “They are potentially volatile.”

“Interest only loans are good for banks but not for consumers,” said Ron Christner, Ph.D., an associate professor of finance at Loyola University. The advantage of homeownership is building equity, which doesn't occur with interest only loans. For the majority of Americans, their largest asset is their home, Christner said, and "by choosing not to pay the principle, you are giving up your best way to build wealth. In fact, these loans can make you less financially successful because you are putting off building equity.”

“In the long run, the cost of these loans is higher,” said Charley Dorand, an investment adviser with Next Financial Group Inc. in New Orleans. “You have to pay the principle eventually and when the interest only period is over, you have less time to pay the principle. And, you are paying a higher interest rate on the remaining balance.”

Christner is concerned that these and other types of adjustable rate loans could lead to an uptick in foreclosures in the near future. Since the interest only mortgage option is relatively new, there is no data related to potential foreclosure rates.

Homeowners who used these types of loans to push their borrowing power to the limit are particularly vulnerable. “I do think some people will eventually be blindsided when their term ends and they are stuck paying the principle with higher rates,” Crozier said. “It could spell trouble for them.”

Some borrowers may also lose money if they sell their home. “They may get nothing at closing,” Coffman said. “In that situation - which is rare -they would be no better off than if they had been renting.”

Banks and borrowers could both lose out if home values stagnate, or if there is inflation coupled with a declining real estate market, Crozier said.

Last year, interest only mortgages accounted for five percent of the New Orleans mortgage market, a 5- to 10% increase over 2003, said Coffman. Traditional 30-year fixed rate and 5-year adjustable rate mortgages comprised 95 percent.

“One thing to remember in the money business is there's no free lunch, Coffman said. “In the end, the only person taking the risk, whether the loan is fixed or adjustable rate, is the borrower.”