In an article earlier this year, I discussed some pros and cons (mostly cons) of interest-only mortgages. In an effort to prolong the U.S. housing boom, finance companies are peddling these mortgages to the average homebuyer, setting everyone involved up for trouble down the road.
Traditionally the province of wealthy individuals looking for tax advantages, interest-only mortgages have become a panacea for homebuyers looking to buy, frankly, more house than they can afford. It's estimated that 10% to 15% of all new mortgages in 2004 were of the interest-only variety, compared with an historical average of less than 2%. With big lenders such as Countrywide Financial (NYSE:CFC), Wells Fargo (NYSE:WFC), J.P. Morgan Chase (NYSE:JPM), and Washington Mutual (NYSE:WM) (to name just a few) promoting these mortgages to average buyers, taking on an interest-only loan has become acceptable, and even somewhat chic. Even smaller banks, such as Provident Bank of Maryland -- a unit of Provident Bankshares (NASDAQ:PBKS) -- are in on this action.
The dangers of an interest-only mortgage are clear. Initial payments are artificially low (no principal), so when the principal amortization begins, monthly payments will skyrocket. The majority of people taking interest-only mortgages are stretching their monthly payments to the limit, betting that either their income or the house's value will rise, or both. Adding fuel to the fire, many interest-only mortgages are also ARMs, introducing the double whammy of higher interest rates to principal payments down the road. When payments start jumping, don't be surprised to see many of these houses hit the market, as overextended borrowers rush to get out from under the crushing debt. That's when you'll see the housing market decline, at least in some areas.
Here's an example. Let's assume that Johnny Homebuyer is approved for a mortgage payment up to $1,500 per month but needs a $350,000 loan. With an interest-only mortgage at an interest rate of 5%, Johnny can just barely afford it. When principal amortization begins five years down the road, if rates have moved just to 6%, he's looking at a new monthly payment of about $2,255. Better hope he gets a big raise.
In general, however, I wouldn't panic. Most people with interest-only mortgages today will simply be forced to refinance over a new 30-year period and cut back on the Starbucks (NASDAQ:SBUX). Not a great scenario, but not the end of the world either.
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Fool contributor Chris Mallon owns shares of Provident Bank through his private investment partnership.
