SubPrime (or Bad Credit) Interest Only Mortgages
If you are shopping around for a mortgage, you will invariably run into “interest-only” loans. These loans have a set term (e.g., 30 years) just like regular mortgages and can have adjustable or fixed rates. The difference is that in the first years of the loan, you are only required to pay interest on the amount of money borrowed. These interest-only period can vary widely from two to five years typically in the sub-prime market or ten to fifteen years in the prime market with Fannie Mae products such as InterestFirst.
Lower Payments
Interest-only mortgages are popular because of the lower payments at the beginning of the loan. This may mean you can qualify for a more expensive home, as some of the sub-prime lenders will calculate your debt ratios based on the initial interest-only payments. These types of loans are especially useful in pricier housing markets and areas where property values are increasing. If your property value increases, you are inadvertently building equity in your property without paying down the principal. Be cautious though if you are really stretching just to make that interest-only payment because it won’t last!
Payment Increase
After the interest-only period is over, your monthly payment will become fully amortizing. That means that you will now be required to pay both the principal and the interest on the loan. If you have been making the minimum monthly interest-only payments during the early years of your loan, your loan balance will be the same as it was the day you began making payments. When considering an interest-only loan, make sure you can afford the higher payments that will come after the interest-only period is over.
Fixed Rate Vs. Adjustable
Interest-only mortgages are safer with a fixed interest rate rather than with an adjustable rate. Your initial interest rate on an adjustable mortgage is completely in dependent of any interest-only feature. For example, you may be enticed to take out an interest-only mortgage on a 2/28 ARM. Not only will your rate adjust after two years, but it will become fully amortizing at that adjustable rate in five years. This could lead to a significant increase in your monthly mortgage payment. Sub-prime lenders typically have a minimum credit score requirement on their interest-only loans because of the increased risk of default.
When is a Sub-prime Interest Only Mortgage a Good Idea?
So when is a sub-prime mortgage a good idea? If you are in an area where property values are increasing, you could offset some of that lost equity from not paying down the principal. Also, your entire interest-only mortgage payment is tax deductible. If you are saving $250 a month with an interest-only payment and can invest that $250 in a high-growth mutual fund or in stocks, you will certainly come out on top. Earning 12% interest on a $250 a month investment over five years is certainly better than borrowing that money at any interest rate.
Be Realistic About What You Can Afford
The bottom line is to be realistic as to what you can afford. You know your spending habits better than your mortgage broker, so don’t look for a house in a certain price range just because that’s the amount you are told you’re allowed to borrow. 100% interest-only financing can be particularly dangerous if home values plummet and you want to relocate. You may find yourself unable to sell your home for what you paid for it, in addition to any realtors’ commissions or other closing costs. But if you are careful about your spending habits, comfortable with your monthly payment and can afford the maximum possible payment when the loan becomes fully amortizing, an interest-only mortgage may be a wise choice.
