Interest-only mortgages: A great cash flow toolJoseph Badalinterest-only, adjustable-rate mortgages
The recent fervor in the financial press about the pitfalls of
interest-only adjustable-rate mortgages (ARMs) was predictable as
soon as interest rate increases began to occur. Typically, articles
from the financial press regarding interest-only ARMs do not
distinguish between the segment of the population that should never
borrow on an interest-only basis and those for whom the
interest-only loan is a wise financial planning tool.
There is a tendency on the part of the financial press to focus
on the average American homeowner and to draw conclusions based on
what pertains to that average American. As with just about
anything, conclusions based on the average can lead to inaccurate
and misleading perceptions. The ARM (particularly the interest-only
ARM) has suffered from this sort of generalization.
Clearly, an interest-only mortgage is not a viable option for
the homebuyer who can only qualify for a mortgage loan based on the
interest-only option. Still, there is an enormous group of
homebuyers who do not fall within this category, and for these
borrowers, interest-only ARMs may be used as an excellent financial
planning tool to increase the borrower's cash flow and afford a
level of financial flexibility and freedom the traditional
fixed-rate mortgage cannot provide.
During the last decade, the mortgage industry has seen
financially savvy homeowners and their financial planners employ
the interest-only mortgage as an integral component for reaching a
borrower's overall financial goals.
Even in the early years of a mortgage, when the principal
component can be relatively low, this arbitrage condition can
accrue to the benefit of the borrower in a substantial fashion. For
instance, on a $1 million loan (a 10/1 ARM at seven percent,
generally having a maturity of 30 years, with a fixed interest rate
during the first 10 years and an annual adjustable rate
thereafter), the borrower can realize approximately $49,182 in cash
flow savings over five years and $98,364 over 10 years simply by
choosing an interest-only option.
In actuality, the borrower's savings can be even greater because
of the difference between the interest rate on a 10/1 ARM and a
30-year fixed-rate mortgage. The difference in the interest rate
between a jumbo 10/1 ARM and a 30-year fixed-rate jumbo loan can be
anywhere from 0.5 percent to one percent. A jumbo loan is any
residential mortgage with a loan amount greater than $417,000,
which represents the limit set by the Federal National Mortgage
Association (FNMA) and the Federal Home Loan Mortgage
Corporation (FHLMC). Because the investor market for jumbo
loans is more restricted than the market for conforming loans (FNMA
and FHLMC are only authorized to purchase conforming loans) and
because most lenders view jumbo loans as being more risky, jumbo
loans usually carry a higher interest rate. Normally, fixed-rate
loans are not available on an interest-only basis. So the
difference in monthly payment between a $1 million 10/1
interest-only ARM at seven percent and a fully amortizing 30-year
fixed-rate loan at eight percent is $1,504.32. The savings in cash
flow would be $90,259 over the first 60 months and $180,518 over
the 10-year fixed-rate term of the ARM. In other words, the
borrower could invest a cash flow stream totaling $180,518 over a
10-year period in an alternative investment that could generate a
net yield in excess of the seven percent gross interest cost of the
mortgage. Since mortgage interest is deductible, the actual savings
are even greater.
There are specific circumstances in which an interest-only ARM
may be the savvy choice for a homeowner. For instance, if an
individual who knows he will only be in a property for a short
period of time (e.g., the borrower will have a work-related
relocation in three years, is planning to retire and downsize, or
has a growing family and needs to upsize), borrowing on an
interest-only basis makes a lot of sense.
While the interest-only ARM is not for everyone, it is a viable
financing mechanism for the segment of the population that can
afford the risks associated with the product. Ironically, the ARM
came into popularity as a result of high interest rates in the late
1970s and became the product of choice for many first-time
homebuyers. As a financing tool, the ARM allowed people to qualify
for a mortgage who could not do so with a fixed-rate mortgage.
Today, the ARM (particularly the interest-only ARM) has been
adopted by the more affluent members of our society - not as a
means of qualification, but as a financial planning and cash flow
device.
Joseph Badal is the CEO and chief lending officer of Santa
Fe, N.M.-based residential mortgage lender Thornburg Mortgage. He
may be reached at (888) 898-8698 or e-mail
[email protected].
