The 30-year fully amortized loan has been the mainstay of real estate financing in the U.S. for decades, yet market conditions often bring about different types of mortgages to help buyers get into a home. At one time, there was a loan called FHA 245, which was a graduated payment, negative amortizing loan. The payments were kept low because the shortage of what the payment should have been was added to the loan balance each month. This worked decently in an accelerating market, but not so well in a declining market.
Another tool to help buyers in an accelerating market is the interest-only mortgage. During the pre-2007 real estate market, prices were rising rapidly, and this was a tool to help keep the payment lower. During the 2007 to 2012 recession, interest-only mortgages got a bit of a bad rap because consumers were missing out on getting the loan paid down. As values declined and the loans weren’t being paid down, the homeowner became more likely to be foreclosed upon.
When a market accelerates, interest-only mortgages become more commonplace. This is because home prices are accelerating faster than salaries, and the consumer looks for ways to afford a home.
There is definitely a time and place to use the interest-only loan as a tool.
One example I have is when I had a client who had been laid off from his job. This client had other income but the fully amortized payment was making things pretty tight. By using an interest-only mortgage he was able to reduce his payment and stay in his home.
A feature of interest-only loans is that if you prepay any principal, the next month, the interest-only payment is based on the remaining principal balance. That means the payment goes down immediately. That is a big difference from a 30-year amortized loan. On a 30-year amortized loan, if you pre-pay principal, it reduces the term of the loan, but the payment remains the same. With the interest-only loan, if you are disciplined enough with making extra principal payments, the monthly loan payment will go down each time you do.
Interest-only loan availability varies based on market conditions. Typically, when these loans return to the market, they first are available for primary residences and second homes. The typical product structure is 3,5,7 or 10 years fixed, then becomes an ARM (Adjustable-Rate Mortgage). In general, qualifying is more stringent than for a typical mortgage and the down payments are larger.
When available, an interest only loan on investment property is an amazing tool. Each time you make an extra principal payment, next month’s payment is lower, and the cash flow gets better.
As the cash flow improves, you can keep applying the increased cash flow to principal –and before you know it the loan is paid off!
Contact a mortgage loan professional to see if an interest-only loan is available and if it is something that would work for you.
By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. He has been awarded two of the highest honors bestowed by RE/MAX International: The Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, email [email protected], call 303.441.5611 or visit boulderco.com.