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Beyond traditional credit

National Mortgage Professional
Nov 07, 2006

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 lendingpartners@thornburgmortgage.com.
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