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Most Popular * Change Type Size * * * * New fixed-rate, interest-only mortgage surges in popularity Ruth Simon Wall Street Journal Apr. So-called fixed-rate interest-only mortgages allow borrowers to lock in an interest rate for the life of the loan, while reducing their monthly outlays by paying interest and no principal, typically for the first 10 or 15 years. These loans, which barely existed two years ago, now account for roughly 8 percent of all new residential mortgages taken out, says UBS AG, a financial services firm. The growing demand for fixed-rate interest-only mortgages underscores the adjustments borrowers are making as mortgage rates have climbed to their highest levels in recent years and the gap between short-term and long-term interest rates has narrowed. Rates on 30-year fixed-rate mortgages currently average 662 percent, according to HSH Associates in Pompton Plains, NJ, the highest since July 2002. The cost of adjustable-rate mortgages, which many borrowers have long relied on to lower their monthly payments, has climbed even faster. Rates on one-year ARMs now average 581 percent, the highest since September 2001. advertisement Banks are taking advantage of the new demand. US Bancorp added fixed-rate interest-only mortgages to its product lineup in September. These mortgages now account for 8 percent of the bank's new mortgage loans and loan volume for the product "is growing every month," says Dan Arrigoni, president of its home mortgage unit. The Minneapolis-based lender has at times offered special lower rates to promote the loans, which allow for interest-only payments in the first 10 years of either a 20-year or 30-year fixed-rate mortgage. The company says first-time home buyers have been the biggest customers for the product. Borrowers who make interest-only payments on a regular basis don't build up any equity in their homes, apart from any increase resulting from rising property values. And homeowners can be hit with sharply higher monthly payments once the interest-only period ends and the borrower is then obliged to repay the balance of the mortgage over the rest of the loan's term. Payments in the loan's later years include both interest and principal. What's more, the savings aren't as great as borrowers might imagine. That's partly because fixed-rate interest-only mortgages typically carry a rate that is one-eighth to three-eighths of a percentage point higher than the rate on a traditional 30-year fixed-rate mortgage. A $300,000 standard 30-year fixed-rate loan with a 662 percent rate would have a monthly payment of $1,920. By comparison, payments on an interest-only mortgage with a 675 percent fixed-rate are $1,687, for a savings of $233 a month, according to HSH Associates. That monthly payment could jump 35 percent to $2,281 a month after the interest-only period ends in 10 years, assuming the borrower hasn't moved houses or refinanced the mortgage. As borrowers pay down principal, the required interest-only payment is reduced to reflect the lower loan balance. SH Kim, a manager in the retail food industry, took out a fixed-rate interest-only mortgage for about $640,000 when he purchased a home in Los Angeles last month. "In the beginning stages, when you purchase a home, you have a lot of expenses," Mr Kim says. The interest-only feature "allows you some flexibility." He says he considered an adjustable-rate mortgage, but preferred the security of a fixed rate for 30 years. Fixed-rate interest-only mortgages are particularly popular with borrowers who are financially stretched, according to the UBS analysis, which found that borrowers with these loans tended to finance more of their home's value and were more likely to have a second mortgage. Credit Suisse Group expects demand for these loans to continue to grow, especially among borrowers holding interest-only adjustable-rate mortgages whose loans are about to reset at a higher rate. But some analysts say the savings from taking out a fixed-rate interest-only mortgage diminishes as mortgage rates rise. That's because at higher interest rates more of the monthly payment goes toward paying interest rather than principal. When rates on 30-year fixed-rate mortgages move above 7 percent, interest-only fixed-rate mortgages "become less attractive," says Dale Westhoff, a senior managing director at Bear Stearns. Mortgage analysts say that fixed-rate interest-only loans are less risky than other types of interest-only mortgages. Because the interest-only period lasts for a decade, there's a good chance borrowers will move or see their incomes grow before the monthly payment is reset. Borrowers also know ahead of time just how high their monthly payment will go when the payments reset. Other mortgage lenders also have recently introduced these products. began offering a 30-year fixed-rate mortgage with a 10-year interest-only period. It also added a 40-year fixed-rate loan that is interest-only for the first 10 years. in December began offering fixed-rate interest-only mortgages to borrowers with jumbo mortgages, currently loans above $417,000. Until then, the bank had made these mortgages available only to borrowers with lower loan amounts. Mitch Ohlbaum, a mortgage broker in Los Angeles, says fixed-rate interest-only mortgages currently account for about 20 percent of his loan volume. He says nearly all of the borrowers opting for a fixed-rate interest-only loan a year ago would have taken out adjustable-rate mortgages, which currently account for just 10 percent of his loan volume. The fixed-rate interest-only loan is the latest in a long line of mortgage products designed to boost affordability. In recent years, borrowers have embraced interest-only adjustable-rate mortgages; option ARMs which carry teaser rates of as low as 1 percent but can lead to a rising loan balance; and so-called piggyback loans that allow buyers to finance up to 100 percent of a home's purchase price. The popularity of these offerings has helped fuel the run-up in home prices and allowed homeowners to tap the equity they had built up in their houses without boosting their monthly payments. But rising short-term interest rates, and a narrowing of the gap between short- and long-term rates, have reduced the appeal of adjustable-rate products, such as ARMs and hybrid ARMs, which carry a fixed rate for several years that then adjusts annually. As a result, borrowers are seeing lower savings in exchange for taking on the risk that rates could be higher in the future. Meanwhile, banking regulators are weighing new rules designed to rein in the use of nontraditional mortgage products that may pose risks to borrowers and lenders. But some adjustable-rate mortgages remain popular with borrowers. That's because the rate on these loans is slightly lower than the rate on fixed-rate interest-only mortgages, and borrowers can lock in a rate for as long as 10 years.
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