Interest Only Loans, Cool or Fool?

Do you remember when Interest Only loans were all the rage? And now I never get a phone call about them, and the only loan that anyone wants is a 30 year fixed-rate (and the occasional 5 Year ARM-fully amortizing by the way). How is it that we can dupe ourselves so easily in the middle of an investment bubble and lead ourselves to believe just about anything? Below is an old e-mail that I dug up that I wrote someone when they inquired about an Interest Only loan. I thought it was interesting.

The story

It is from 2004: “Hello Doug,

Personally, I think the Interest Only (I/O) loans are a poor choice. It’s a certainty that when real estate prices start to run up, that the banking industry rolls out some “creative” loan program to make people qualify, and all kinds of rationalizations are marketed with the program. Here is some interesting information about these I/O loans that you should read, that I happen to know or that I found online:

1). Interest only loans: As the name suggests, an interest only loan requires that you pay only the interest due on the loan for the first five, 10 or 15 years of the loan. It’s a popular option in areas where high home prices have made it tough for buyers to afford monthly payments that include principal and interest.

According to R.J. Arnett, executive vice president of national wholesale lending for MortgageIT, an interest-only loan makes sense for first-time buyers whose incomes will likely go up in the next few years or investors who don’t want to commit to paying principal every month — but could afford to pay the higher amount if needed.

“If you’re the gambling sort, you could get into an interest-only product and bet that the market will build equity for you,” said Gumbinger, explaining that paying down principal is not as much of a concern for people with shorter time horizons, particularly if home prices are going up.

The danger: Homeowners who are using these loans to buy more house than they can afford could get into serious trouble if they don’t budget for higher payments down the road. There’s no a guarantee that prices will appreciate. And if you stay in the house longer than you planned, your monthly payment jumps drastically after your interest-only honeymoon period.

2). The last time the I/O loans were popular was in the 1930’s, does that tell you anything?

3). Here is a good discussion of I/O loans:
http://money.cnn.com/2004/06/25/pf/expert/ask_expert/index.htm. The most interesting part to me is: “But there’s no free lunch. By postponing principal payments, the balance on your loan doesn’t decline and that means you pay more interest over the long run. It also means that when you eventually begin making principal payments, the payment on your loan will jump quite a bit.” I feel like using an I/O loan is like putting your house on a credit card!

4). Do not ask lenders or Realtors what they think about these loans. Most people in the industry are usually not interested in your ability to repay, nor in the safety of your investment, so they LOVE these loans. You have to decide if this type of loan is in your capacity to repay, and if it is safe. No one else will give you a straight answer, and they do not know the answer anyway. The answer lies within you.

So be educated, be careful, and when the time comes we can talk again about all the options on the table and see what is best for you. As you can see, I am NOT a fan of the I/O ARM loan.

Touch base with any other questions, and stay in touch as you proceed in your house hunt.”

What are the conclusions?

I think the lessons here are:
-there is no free lunch
-work with people that you believe care about you as much as their commission.
-if something costs so much that you cannot afford it with traditional financing, maybe you need to pass it up and buy less house.