I. Introduction:
In
the microwave generation, everybody wants things right away. Things
that our elders used to dream of having and save up for are now
available instantly using credit. Credit cards give buyers the option
of purchasing more than they can presently afford and paying back only
interest. But while it may sound like a good idea to have everything
now, for most living at the edge of their means, credit gets out of
control and they get stuck in bankruptcy. A buyer overextending himself
using a credit card is chaos on a small scale compared to the abuses of
credit going on now.
In
recent years, banks have been marketing interest-only mortgages to a
crowd of buyers that want bigger houses, but couldn't otherwise afford
it. Interest-only mortgages allow home buyers to pay a monthly payment
that consists of only interest, no principal. [1] The option to pay
only interest lasts for a specified period of time that usually lasts
from five to ten years.[2] Using a traditional mortgage a home buyer
would be required to make a fully amortizing payment which requires
payments of enough interest and principal for the loan to be paid off
over the term (i.e. 30 years).[3] What gets the interest-only buyer in
trouble is two-fold: no financial cushion in the event of unplanned
expenses, and the termination of the interest-only period.
If there is ever any shift in financial circumstances, the
interest-only borrower presumably already on the periphery of financial
stability has no home equity to fall back on. There are a range of
things that could change financial circumstances from illness to car
trouble to losing a job. When things get rough financially for the
average home owner, they typically have at least the equity in their
home to fall back on. The interest only home owner has not paid any
principal and has zero equity.[4] Realistically speaking, the bank paid
for the house and the "home owner" is merely making rent payments in
disguise while still assuming the risk associated with homeownership.
Secondly, if the interest-only borrower makes it through the
interest-only period without getting tripped up by life's financial
changes, that borrower will still have to contend with the termination
of that interest-only period and the accompanying higher monthly
payments.[5] The payments on the loan will still be measured against
the originally-determined term.[6] For example, if a borrower gets a
$500,000 loan with a 30 year amortization and pays interest only for
the first 5 years, when the sixth year hits they will have to make
payments that would be equal to a traditional mortgage of $500,000 with
a 25 year amortization.[7] This means that the borrower's monthly
payment is even higher than the traditional loan payment they could
afford 5 years ago.
To be fair, there are some borrowers that are good candidates for
interest-only mortgages.[8] Since you are allowed to make a higher
payment than is technically due on an interest-only mortgage, a person
with a fluctuating income can make higher payments when his income
stream is high and interest-only when his income is low.[9] This would
work out as long as the borrower had the sophistication and discipline
to make the higher payments even though he doesn't have to. Also for
those who are sure to have a substantially higher income after the
interest-only period, this type of loan will allow them to skip the
starter house and avoid the transactional cost associated with trading
up.[10] The problem is that most people tend to be overly optimistic
about how much higher their income will be in the future, so they could
be setting themselves up for failure.
With the risk of financial trouble so high because of wanting more
than what is affordable right now, it is amazing that banks are
encouraging this type of homeownership to people who could not afford a
larger home otherwise. For a few buyers interest-only mortgages can be
a rational financial decision. But for most, interest-only mortgagors
are merely engaging in overextended, microwave generation borrowing.
[1] The Principal Facts of Interest-Only Mortgages, HSH Associates Financial Publishers, at http://library.hsh.com/?row_id=58 (last visited April 4, 2007).
[2] Interest-Only Mortgage Tutorial, Mortgage Professor’s Website, at http://www.mtgprofessor.com/Tutorials2/Interest_Only.htm (last visited April 4, 2007).
[3] Id.
[4] Id.
[5] Ben Barros, Interest Only Mortgages: The Next Class Action Goldmine for Plaintiffs’ Lawyers, PropertyProf Blog, Oct. 21, 2005, at http://lawprofessors.typepad.com/property/2005/10/interest_only_m.html
[6] Mortgage Calculator, Interest.com: Your Financial Marketplace, at http://mortgages.interest.com/content/calculators/index.asp (last visited April 4, 2007).
[7] Interest-Only Mortgage Tutorial, Mortgage Professor’s Website, at http://www.mtgprofessor.com/Tutorials2/Interest_Only.htm (last visited April 4, 2007).
[8] Id.
[9] Id.
[10] Id.