Freddie Mac Saying “Bye” to Interest-Only Loans
Posted on February 27th, 2010 by DarcyMore changes are coming on the heels of all this market upheaval. Yesterday, Freddie Mac announced that starting sometime this September, they will stop purchasing and securitizing interest-only loans. For most people these days, this information isn’t really relevant. I seriously can’t remember the last time I did an interest-only loan. Interest-only loans were very popular three to four years ago. They allowed a buyer to qualify for a loan that they wouldn’t have otherwise qualified for. Certainly, there are other reasons for this type of loan, but this was one of the main reasons a person would do an interest-only mortgage.
Suppose before I go any further, I should explain what these are and why I think they, Freddie Mac, are choosing to do this. An interest-only loan is just that, interest-only. There is a period of the loan, usually 5, 7 or 10 years in which all you pay is interest on the mortgage. As I said earlier, this allowed people to qualify for a larger loan, hence, more of a house. Typically, these types of loans carry a slightly higher rate, approximately .125%-.25% , due to the higher risk involved. I will talk about risk in a minute. Let’s look at how this interest-only loan “piqued the interest” of many borrowers.
Suppose you’re looking to do a $350,000 loan (for most of you reading this, this probably isn’t your price range). Figuring a rate of 5% on a 30 year fixed rate, the principal and interest would be $1879. In most cases, you’d add your monthly taxes and homeowner’s insurance to this equation. Of this amount, for the first few years anyway, you’re making a dent in your principal of approximately $400/month. The rest of that payment, the interest, is the cost of your loan — about $1450. As you can see, saving $400/mo is a pretty sweet deal. Gosh, who wouldn’t do this type of loan? In this scenario, I’m not increasing the rate like I should just to make it more of an apple-to-apple example. If you live in the house 4 years, you’ve saved about $24,000. That’s huge.
What you’ve really done is avoided paying off $24,000 of your loan. Now what happens after the 5, 7 or 10 year period? This is where the risk comes in. Your loan would re-amortize for the remaining term using the amount you owe. So, five years later, you still owe $350,000. Now, your payment goes from $1450 to $2046, almost a $600/mo jump. I don’t know about you, but I wouldn’t be able to handle this increase. And hey, look where the market is today — people having to handle increases in payments due to these loans, as well as adjustable rate mortgages. Unemployment is up; home values are down … your whole premise for doing this loan was the fact that values were increasing. So, at the end of that time period, you could easily sell your home and still make out, or just refinance to a fixed rate. Not so much right now.
My opinion is all based on risk. Too many loans have gone bad. With the market not improving, it’s leaving people upside-down in their mortgages, no options but to let the house go or negotiate with the bank to sell on a short sale. Short sales aren’t any easier to deal with than foreclosures. Banks see the risk in these types of transactions too — if the seller is looking to do a short sale, then it’s just a foreclosure waiting to happen. It just may be best to “bite the bullet” now when they can get the home sold and avoid the costs to foreclose on a home. Quick definition for short sale: seller can only sell house for going market, which is less than what they owe on the home. They negotiate with their lender to accept an offer “short” of what is owed on the loan.
Okay, so I got off the subject a bit. In a nutshell, there is good reason for Freddie Mac to say “whoa” to doing interest-only loans. They are just a high risk in today’s market. My guess is lenders will stop doing these with Freddie Mac before it’s “official”. Here’s the bummer about this — first, there could be a high potential that Fannie Mae follows suit on this leaving interest-only loans non-saleable. But honestly, there are some situations and buyers that these loans work REALLY well for — someone who is transferred often for work. Thought process here is why invest principal into a home you’ll only be in a few years? Also great for those who are making income that isn’t really usable for qualifying, such as tips, commissions, bonus — income that requires a two-year history to use and the borrower doesn’t have that. If you know you have or will have that income, an increase in payment may not be an issue at all. Some people are very savvy about investments. Why not do this type of loan to “arbitrage” and use the savings to build up other investments. And last, there are a lot of retired people that this is a great way to have a lower payment since they’re on a fixed income. Eventually the home will transfer to other family members. No need to really care about whether they paid off their loan or not.
Needless to say, it’s a great way to avoid risk for Freddie, and who knows, they may bring it back in the future. I just don’t know if I agree that taking it away completely is the answer since it really has and can help many people. That’s my 2 cents on this upcoming change to the world of mortgages!
I know APR loans are a bad idea, but how would an interest-only loan work? Would it still be a 30 year note, or do they extend the loan?
Great question! My guess is you’re referring to an ARM, adjustable rate mortgage. For interest only, the term is normally 30 years, though you can do a shorter term if you want. Interest only just means you’re paying just interest on the loan, no principal. After the interest only term, the loan reamortizes for the remaining term, so if 30 year, the first 10 are interst only and then whatever is owed is reamortized over 20 years to determine your payment. The ARM is different, as long as it’s not interest only, in that your payment can adjust every 6 months, year or after a fixed period of say 3, 5, 7 or 10 years. Hope this helps!