Yesterday, Consumerism Commentary reader Ryan suggested I write about interest-only mortgages.
There is no such thing as an “interest-only mortgage.” Wouldn’t that be nice, though, to have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, when you become a borrower, your lender will insist upon receiving interest payments as well as principal at some point. What does exist, however, is an interest-only payment option for mortgages. The interest-only payment option can apply to adjustable-rate mortgages and fixed-rate mortgages alike. The purpose is to allow borrowers to reduce monthly payments for a period of time. Rather than a monthly payment of $1,200, in which $600 goes to interest and $600 goes to the principal, the monthly payment would only be $600.
The lower monthly payments during the interest-only period are good for households with irregular income such as commission payments less frequent than monthly, or households with unpredictable income, like that of a business owner who is expecting low income while the business is in a period of growth.
Interest-only payment options also allow borrowers to “afford” a more expensive home. This can be important for an executive who needs to entertain clients at home and its appearance is crucial to career success, but there could be a strong desire to use the lower payments to buy a home beyond the means of the borrower.
This is a dangerous prospect, especially in an environment where we can’t be sure whether the value of the house will rise in the short term. While making interest-only payments, the borrower is not building equity in the house. if the borrower is not building equity, the concept is similar to renting, particularly if home values are stagnant or decline. The amount you owe on the mortgage will never decrease. Even worse, some interest-only payments don’t cover the full amount of interest due each month. The excess, non-paid interest would then be tacked onto the principal, causing the borrower to owe more in principal than the home was worth when purchased.
When house values are declining, like they have been in many areas of the United States, this problem is compounded. Not only does the borrower owe the full purchased value of the house while making the interest-only payments, but the house’s declining values means the borrower will quickly owe more than the home is worth. Then, if it is sold, the borrower could owe more money to the lender than he received in the sale.
Interest-only payment options don’t last forever. After the interest-only period ends, the lender will expect the borrower to start paying back the principal. This can result in a significant increase in the number written on the checks sent to the lender. If the income hasn’t increased as expected or if the business has not moved past the “growth” stage, the new payment — a larger payment than you would have had throughout the life of the mortgage if the interest-only option was not selected — might be unaffordable.
The Federal Reserve Board has a helpful comparison chart outlining the differences in payments you might expect if you choose an interest-only payment option, reproduced below. Notice how low the equity is in the last column, identifying borrowers who opt for the interest-only method.
Do you have or have you had an interest-only payment option on a mortgage? Please share your experiences or opinions.
Occasionally, readers email me with questions about their own personal finances. Considering I share so much of my own, it’s always interesting to get a peek into the issues other people are concerned about. In fact, right now, I am actively seeking reader questions to serve as launching points for a discussion I plan to have with Ramit from I Will Teach You to Be Rich.
I always remind people that I am not a financial professional, and whenever seeking free advice, you get what you pay for. But that doesn’t mean I can’t have some opinions or thoughts, and by sharing questions with Consumerism Commentary readers, we can usually come up with some good suggestions.
Here is the latest question I received, from Gerry:
I currently have two rather large students loan. One at $30,000 (4.5%) and one at $15,000 (2.5%). I pay about $300/month towards the larger one and $125/month towards the smaller one.
I was wondering if any bank might ever offer a 6 month or 12 month loan at a lower interest rate. Could I take a $2,000 or $3,000 loan and throw it at the larger loan and pay the bank back instead. Would this even make sense for me?
Note: I am also in school, so my loans are in deferment, but I still make the above payments.
The reader is off to a great financial start by beginning to pay off deferred student loans while still in college. In most cases, students do not need to begin paying off student loans until six months after they end their enrollment (preferrably at graduation), so this head start will be beneficial when living expenses increase a few years down the road.
It’s hard to find better deals for borrowing than student loans. There is only a low probability of finding a bank that will offer a loan at a lower interest rate than 4.5% to pay off an existing loan. If finding a rate lower than 4.5% is important, I would suggest using your “social capital” and ask for the money from a relative. This is a risky proposition; personal loans can be dangerous for the health of the relationship, so this is an option one should consider carefully.
Students with deferred loans have the flexibility now not to make payments if they are causing a financial strain. I would consider taking advantage of that flexibility when it is available. While it’s admirable to pay off the loans early — no debt is “good” debt — student loans are deferred because it allows students to focus on their education rather than trying to find work to create an income.
Am I off the mark? What advice would you give Gerry?
Occasionally, Consumerism Commentary readers email me with financial questions. If you want to see a topic discussed here, you can do this as well. Just email me at flexo or tips at this domain name. I can’t answer every email personally, but I’ll do my best to connect you with the resources you need.
Last week, I received this question from Justin about auto loan refinancing:
I’m interested in refinancing my car loan. I was younger and dumber when I bought my car, so I didn’t pay much attention to the financing side of it. I am currently in a 11.96%, 72-month loan, and I’ve knocked off about 2 years so far. I have good credit so I know I could get a better loan. Do you at least have some tips for me as to where to start looking?
With good credit, you should definitely be able to find a better deal, saving you hundreds if not thousands of dollars over the course of the loan. My first inclination is to check BankRate for a comparison of rates for auto refinance loans. Interestingly, the only loan available through BankRate for my location was a 36-month loan through a lender called “up2drive” for 6.90%. I am not convinced that BankRate is providing me with a full picture of what might be available.
I would start with the local banks with whom I already have a relationship. For me, this would consist of Wachovia and TD Bank, but if you are a member or could become a member of a credit union, they often can provide deals you may not find from a traditional bank.
If you’re interested in comparing refinance options to determine how much you might save through the course of the loan, take a look at this calculator. It is designed for home mortgages but the calculation is the same for auto loans.
When you do refinance, unless you choose a shorter period than your original loan, you’ll be extending the total number of payments you’ll make, although those payments will be smaller. I would suggest, if possible, to pay more than your monthly amount if the terms of your new loan don’t penalize you for doing so. To make the most of the money you spend on cars,, pay off the loan as soon as possible and keep the car as long as possible. Don’t feel that you need to buy a new (or new-to-you) car once you stop sending monthly payments to the bank.
I have never refinanced an auto loan. I’ve had loans on two cars at different times, both Honda Civics. The first I sold when I no longer needed a car for work, and used the proceeds to pay off the loan. The second was financed outside of the banking system at a low rate at 2%. This was a loan with a family member, a situation that led me to go outside a strict debt avalanche system and pay off the debt as soon as possible.
I would welcome additional comments and suggestions from readers who have experience with auto loan refinancing or who have thoughts to share on the topic.
Photo credit: tomsaint11
If you have a loan serviced by Sallie Mae, there is a good chance that your FICO credit score dropped significantly recently. Consumers have identified an error in Sallie Mae’s reporting. Accounts in good standing have been flagged and notated with the wording, “Arrangements made with credit grantor to make partial payments.” Sallie Mae is reporting the your loan balance is fully due immediately and that your payments are behind more than 60 days.
This reporting error has caused FICO scores to drop about 150 points. This can be a pricey error for anyone planning to close on a mortgage. As of now, the error is isolated with Equifax, but Experian and Transunion may be affected as well.
If you have a loan with Sallie Mae, particularly if you opted for a “graduated payment plan” in which your total payments increase over time, I suggest taking advantage of your free annual credit report from Equifax right away and disputing any incorrect record.
Also contact Sallie Mae at 888-272-5543 if you believe they are reporting your loan information incorrectly.
May 14, 2008 Update. This story has been picked up by BusinessWeek and the Pittsburgh Post-Gazette. The problem at Sallie Mae affected an estimated one million customers. BankRate provides this information:
Sallie Mae is working with Equifax to correct borrowers’ credit reports. Credit scores should return to their standings before the drop within “the next day or so,” and any erroneous delinquencies resulting from the misinformation should be removed from the borrowers’ Equifax credit reports… All credit reporting agencies have been notified of the issue and consumers do not need to pull their credit reports if they have not already done so, nor do they need to dispute the error with the credit bureaus… They should call Sallie Mae directly.
MyFICO forum thread via a reader
Email this article
Print this article
