Home Loan Financing Basics – Third in a Series

Loan Terms:

Interest only loans have become very popular due to the fact that the monthly payment requires only payment of interest, and does not require a principal amortization payment. Because of this, borrowers may be able to qualify for a larger loan, and therefore be able to purchase a more expensive home, than they would otherwise be able to. The problem with these loans, however, is that the interest-only feature only lasts for a limited time, usually 5 years. At the beginning of the 6th year, however, the lender will require a significantly larger monthly payment which will include principal amortization, with this monthly payment being even higher that that of a 30 year amortized mortgage, because it is being amortized over a shorter period, which is the 25 years remaining on the mortgage. The borrower, of course, may refinance the loan at the end of 5 years, however if interest rates have increased significantly, the borrower may not have many alternatives.

Adjustable rate mortgages had generally been the mortgage type of choice in the recent past due to the previous large spread or difference between short term interest rates and long term interest rates. This had enabled borrowers to qualify for a larger mortgage than for a 30 year fixed mortgage due to the lower interest rate and the resultant lower monthly mortgage payment. The interest rate can be locked in for varying periods, ranging usually from 3 to 5 years, with the interest being readjusted yearly thereafter. The borrower is exposed, however to interest rate risk due to the potential for rapidly increasing interest rates which could significantly increase the borrowers monthly mortgage payment.

The attractiveness of the ARM over the 30 year fixed rate mortgage, however, had greatly diminished from 2005 to 2009 due to the decreasing spread or difference between short term and long term rates. ARM’s were very attractive when there was a large difference between short-term ARM mortgage rates and 30 year fixed rates, and the spread between short and long term rates has decreased significantly. This led many borrowers to reconsider a 30 year fixed rate mortgage, in order to protect themselves from the possibility of rapidly increasing interest rates. In August 2007, however, turmoil in the sub-prime mortgage markets spilled over to the other sectors of the mortgage market, and significantly affected long term mortgage rates for non-conforming jumbo mortgages. These loans are dependent on lenders pooling these mortgages and reselling them as mortgage backed securities in the secondary markets, however investor interest in these mortgage backed securities decreased significantly, therefore raising the required interest rates on these mortgages to make them attractive to buyers, therefore leading to significant increases in jumbo mortgage rates. Rates on fixed rate long term mortgages for conforming loans, however, have not been significantly affected.

Prior to the sub-prime mortgage meltdown in 2007-2008, ARM lenders had offered multiple options as to the amount of the monthly payment. These options included interest only, a fixed payment regardless of the interest amount (which may result in “negative amortizaton”, or an increase in the loan balance, if the loan payment is less than the interest that accrued during the month), or a full amortization payment, which includes both interest as well as the principal payment required to fully pay off the loan over the loan period. Recently, however, many of these options have disappeared as lenders have raised their underwriting standards.