From the Truth about Mortgages Series
Are Interest-Only, Option ARMs, and Other “Exotic” Loans Really Any Riskier Than Fixed Rate Loans?
By Robert D. Ashby, CMPS
Solid Rock Mortgage Corporation
The National Association or Realtors (NAR) and other organizations have issued warnings against these types of loans. It is true that many consumers have misused them and that many mortgage brokers have sold homeowners these types of loans that really shouldn’t be using them. But are they just getting a bad rap because of the lack of understanding how they should be used?
“When used properly, Interest-Only and Option ARM loan products can be extremely beneficial for the homeowner. I cannot over emphasize the importance of planning when using these loan programs,” says Robert D. Ashby, a Certified Mortgage Planning Specialist and President of Solid Rock Mortgage Corporation. Mr. Ashby adds, “No one should be using these loans to qualify for a house they would not be able to otherwise afford.”
The reason these loans are being portrayed as “risky” is due to misuse of these loans by homeowners and mortgage professionals alike. These types of loans are designed more for homeowners that have the discipline to follow through with a professionally designed mortgage plan, just like a family’s financial plan.
Most arguments against these loans do not factor in the benefits of these loans, and instead focus on risks. One recent example was when weighing in on interest-only loans, that it would cost the homeowner more over 5 years. This is typical thinking of those against these mortgages. The truth is that when used properly, the homeowner would use the difference in payments to yield at least the same rate of return, and in reality would be better off.
This is how the argument also assumes the same interest rate on both loans and goes something like this…
Loan Amount |
Int. Rate |
Mo. Pay. |
Difference |
Diff. in 5 Yrs. |
Loan Principal |
Savings |
$200,000 (amortized) |
6.375% |
$1,247.74 |
+ $185.24 |
+ $11,114.40 |
$186,950.49 |
$1,935.11 |
$200,000 (Interest-Only) |
6.375% |
$1,062.50 |
N/A |
N/A |
$200,000.00
(+13,049.51) |
|
When you look at this way, it cost the homeowner more to have the interest-only mortgage. But let’s use today’s rates (6/19/06) and a 5/1 interest-only ARM since FNMA shows the average length of a loan is 4.2 years. When the homeowner is disciplined enough to invest the difference monthly (same monthly expenditure) at a 6% (less than the loan rate) rate of return, easily accomplished these days, here is how the picture looks…
Loan Amount |
Rate |
Mo. Pay |
Mo. Invest. |
Principal in 5 Yrs. |
Invest Rate |
Invest. Bal. |
Savings |
$200,000 (Amortized) |
6.375 |
$1,247.74 |
N/A |
$186,950.49 |
N/A |
N/A |
|
$200,000 (5/1 Interest-Only) |
6.125 |
$1,020.83 |
$226.91 |
$200,000.00 |
6% |
$15,831.52 |
$2,782.01 |
What’s amazing is the homeowner that has the ability to obtain increased rates of return, as well as improves liquidity which is vital in a financial crisis. As you can see, the disciplined homeowner will come out ahead when using the interest-only option and investing the difference.
So now we know the homeowner can be better off with interest-only loans when used properly. What about Option ARMs? Some mortgage brokers sell the Option ARM products without explaining the risks simply because they can make more money on them. Don’t get me wrong, Option ARMs can play a significant role for a homeowner, but again, the homeowner needs to have a mortgage plan and be disciplined to follow through. If the homeowner has a lot of credit card debt and needs a lower mortgage payment, for instance, these programs can offer the ability to pay down that credit card debt by lowering the monthly payments. They are also a fairly good product if the homeowner needs to increase their liquidity fast and cannot afford to take cash out during their refinance.
“The problem with Option ARMs is that many Americans do not use this product correctly. They tend to consume the savings available with this product, thus costing them enormous amounts of money and potentially leading them to foreclosure,” Mr. Ashby comments. He continues, “I only like Option ARM products when the homeowner understand the risks and has the discipline to use the savings wisely. Most often these products have a 3 year prepayment penalty leaving the homeowner locked into the loan or face a hefty ‘fine’.”
Option ARMs are usually adjustable on a monthly basis. The risk here is minimized by using indexes that do not change dramatically monthly, but can change significantly from the time the loan was originated. Also, these loans can be “recast” when the principal balance reaches a predetermined value, resulting in an immediate payment increase that the homeowner may not be prepared for. This is a likely scenario for those who took out this loan about fairly recently as the indexed rates have risen and the minimum payment was based on a 1% rate.
In summary, the interest-only and other “exotic” loan products may be better for the homeowner, when used properly. They are getting a bad reputation because many homeowners and mortgage professionals have used them improperly, making them more costly. The bottom line is a mortgage is a financial tool and cannot be taken lightly. You wouldn’t go to an optometrist to get heart surgery, so you should seek a Certified Mortgage Planning Specialist when preparing your home purchase or refinance.
For more information about the truth regarding how to incorporate a mortgage into your overall financial plan, visit www.solidrockmortgage.com or contact Robert D. Ashby at (954) 432-3450.
About the author: Robert D. Ashby is President of Solid Rock Mortgage, a licensed Mortgage Brokerage Business in the state of Florida. He has been in the financial services business since 1998 and obtained his Series 6 and 63 Securities Licenses as well as Life and Health Insurance Licenses in the state of Virginia. He moved to Florida in 2002 and decided to focus solely on mortgages, obtaining his Mortgage Broker License for Florida in 2003 and then opening Solid Rock Mortgage in 2004. He has become Florida’s first Certified Mortgage Planning Specialist and Florida’s Debt and Equity Management Expert.
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