Betting the House on Interest-Only Loansby Tim Manni
“If you purchased your home with an interest-only loan between 2003 and 2006, you’re cooked.”
-Mark Goldman, a San Diego mortgage broker
Forget subprime loans, it’s “exotic” loans that are now keeping homeowners and real estate analysts up at night. Interest-only and pay-option loans were selling like hotcakes during the housing boom, and, unlike subprime loans, many of the borrowers with these “exotic” loans are still in their homes, planning for the day their loans reset.
“This is going to be the source of tomorrow’s troubles,” said HSH VP Keith Gumbinger. “The borrowers might have thought these were safe loans, but it turns out they bet the house.”
Why so glum — can’t these borrowers just refinance into a new loan? The problem is that home price declines have caused waves of borrowers to be underwater — unable to refinance. If all you have paid was the interest on your loan for the first five, seven, or 10 years (those are the options), and your home has dropped in value, it’s like “…heading straight for a big wall and you can’t put the brakes on,” says John Karevoll, a longtime senior analyst for MDA DataQuick.
Part of the recent housing rescue initiative allowed Fannie Mae-owned loans to refinance with loan-to-value ratios of up to 125%. But in states like California, Fannie’s loan limit of $417,000 wasn’t large enough to cover a home in a middle class neighborhood during the housing boom.
To some, this post may sound overly-negative, even contradictory, especially since the housing market is showing some real signs of vigor at the moment. Presently, many sectors of the housing market are picking up, but it’s what lies ahead that’s cause for concern:
Still, interest-only loans represent an especially large problem. An analysis for The New York Times by the real estate information company First American CoreLogic shows there are 2.8 million active interest-only home loans worth a combined total of $908 billion.
The interest-only periods, which put off the principal payments for five, seven or 10 years, are now beginning to expire. In the next 12 months, $71 billion of interest-only loans will reset. The year after, another $100 billion will reset. After mid-2011, another $400 billion will reset.
So we know the problem exists, what can we do to fix it? First off, if you have used your smaller interest-only payments to bank more money each month, then you may not be in such bad shape when your payment resets. If you haven’t, it’s time to start paying a little extra each month to whittle down the outstanding principal. This will help make the shift to fully-amortizing payments (interest plus principal) slightly easier on your budget.
Here’s Our Take: Interest-only loans are going to be a problem — we’re not denying it — but we don’t agree with Goldman’s assumption that everyone who purchased a home with an interest-only loan between ‘03 and ‘06 will be doomed.
Here are several factors for not only interest-only borrowers, but for analysts as well to consider:
- Home Prices: while we can’t forecast the exact direction of future home prices, it’s likely that prices will begin to trend upward from the depths they have fallen to in recent months, increasing the ability of borrowers to refinance.
- Interest Rates: since the Fed has stated that one of their main goals is to keep interest rates low for an “extended period,” the upcoming rate reset may not be as dramatic as many fear.
- Borrower Behavior: The majority of interest-only loans have an adjustable interest rate attached to them. If you signed up for an ARM, you know a change in your rate is coming. The fear or assumption that interest-only borrowers will be doomed when their rate resets projects the notion that borrowers are incapable of handling any changes to their finances. “If that’s the case, it’s going to be a long winter because heating bills go up,” said Gumbinger.