San Francisco – Once a frustrated renter, Chris Economou is now a happy homeowner, enjoying a splendid view of San Francisco and an $80,000 increase in his property’s value since he bought his one-bedroom condominium for $435,000 a year ago.
He credits his good fortune to an interest-only mortgage, an increasingly popular – and risky – loan that enables borrowers to lower their monthly payments enough for several years to afford rapidly escalating home prices in expensive markets such as the San Francisco Bay Area. Economou estimates that he saves $1,000 a month by having an interest-only mortgage instead of a traditional 30- year fixed-rate loan.
“I’d still be looking at renting for a long time,” if not for that mortgage, said Economou, 33. “Home prices are so high that it’s about the only way young people like me can get into the market.”
Built on the assumption that home prices will continue to rise, interest-only mortgages represent a gamble that many home owners accustomed to conventional fixed-rate loans would never take.
Unlike conventional 30-year mortgages, interest-only loans typically don’t require payments toward the principal for three to seven years, substantially lowering the costs of entry and making it easier to qualify for the loan.
But the financial firepower of interest-only mortgages is affecting all homeowners. They are further elevating already lofty housing prices, a trend that’s raising fears of a crash that could plunge the economy into a recession.
The growth of interest-only mortgages reflects a fundamental shift in the way many Americans think of their homes. Rather than places to grow old in, homes are seen as part of investment portfolios – in fact, a much better bet than the stock market in recent years. Even borrowers who can afford the higher payments of a conventional mortgage are opting for interest-only loans so they can free up more cash to invest in retirement plans, college education funds or other home purchases, said Mark Carrington, director of information products for LoanPerformance, a mortgage research firm.
“Borrowers are becoming much more educated and smarter about what a mortgage really is,” Carrington said. “They are using it as just another investment tool in their overall financial plan.”
San Francisco accountant Patrick Duffy advises his clients to use interest-only mortgages, unless they plan to live in a home for at least seven years.
“If you are only going to have it a short time, why waste your money” on the higher monthly payments required under a conventional 30-year mortgage, reasons Duffy, who financed both of his homes with interest-only loans.
With some of the nation’s highest home prices, California has become ground zero for interest-only mortgages, especially in the Bay Area.
Large numbers of homebuyers also have been relying on interest-only mortgages in hotter markets in Florida, Nevada and Arizona, according to the market research firm.
The home-buying frenzy reminds Yale University economics professor Robert Shiller of the mania that gripped the stock market during the Internet-driven boom of the late 1990s.
Shiller warns that the housing market is creating the same kind of investment bubble that led to the stock market’s three-year meltdown.
“This is new territory for the real-estate market,” Shiller said. “There’s been a major attitude change that’s caused people to become very speculative about home prices. All the fear (of a market correction) seems to be gone.”
A sharp downturn in housing prices could turn interest-only mortgages into financial albatrosses, saddling borrowers with homes worth less than what they owe.
A double whammy like that would raise the chances of borrowers falling behind on payments or, in the most extreme cases, walking away from their homes, raising the specter of the massive foreclosures that contributed to the taxpayer-backed bailout of the savings-and-loan industry in the late 1980s.
Federal banking regulators are so concerned that they’re talking openly about regional housing bubbles and considering new guidelines for lenders to guard against taking on too much risk, said Steve Fritts, acting deputy director of the FDIC’s Division of Supervision.
“There are people who are pushing the envelope,” he said.
Less cash at first, but more due later
Unlike a conventional 30-year mortgage, interest-only loans don’t require payments toward the principal amount anywhere for the first three to seven years. After that initial grace period, borrowers face much higher monthly payments.
In contrast, a conventional 30-year mortgage with a fixed rate amortizes the financing costs over the life of a loan – a formula that generates higher monthly payments than an interest-only loan during the first three to seven years.
A conventional 30-year mortgage for $650,000 with a fixed rate of 5.625 percent would require monthly payments of $3,742, according to Michael Harrington, president of Summit Mortgage Advisors in San Francisco. An interest-only loan with a fixed rate of 5 percent for the first five years of the mortgage would require monthly payments of $2,708 during the first 60 months.
In the first five years of the loan, the borrower with the conventional mortgage would lower the outstanding debt to about $602,000. The borrower with the interest-only mortgage still would owe $650,000.
