I've just read the third thread of the day on Interest-Only loans, and not a one of them has got it totally right about what they are, their benefits and pitfalls.
I know, I know, I'm setting up myself as a knowitall. But I really think many Democrats are missing the boat on these loans.
More, below the fold.
First, I know there's a political question to address here. These loans may add to an economic collapse that a great many people fear. But the overgeneralizations and misconceptions about these loans do nothing to help us understand what's happening out there, and what's at stake.
I recognize that IO loans are being abused, they're being peddled to people who can't afford a conventional mortgage. This is because of some unscrupulous lenders who either don't care about their company's financial well-being or else they expect someone else to save their butt in case of a collapse.
But let me go back a bit and give background on interest-only loans. These were mortgage vehicles which came about after the deregulation of the financial lending industry in the 1990s. In the wake of that deregulation, IO loans popped up. They practically didn't exist before then. One might ask two questions about the confluence of the deregulatory actions with the offering of these loans. One, why didn't banks offer these loans before deregulation? Two, why do banks market these loans to people who can't afford conventional loans?
If you answer these two questions, you begin to realize what's at stake in the offering of IO loans. First, banks don't like these loans for average homebuyers because the homebuyer doesn't build equity on the house. Banks profit on that equity by collecting interest on it. You pay the bank principal, and the bank sits on that principal for 30 years. You don't make a single penny off it. That's why banks never offered IO loans before deregulation. There's a considerable amount of money tied up in equity during the life of your conventional mortgage, and the only one that profits from that money is your bank. You don't see that equity until you sell your house or until your fulfill the mortgage.
So, who began offering these loans? Investment companies. They realized that they could make money off the interest on the loans and they didn't have to bother with sitting on equity. Instead, they hoped you would invest the cost savings (you pay less monthly with IO loans) in their funds. These investment companies would then profit from your investment. The same as the banks profit on your equity.
While the banks and investment companies were vying for business, a third track opened for consumers. The possibility existed that we could both keep our money (not lending it to the bank for equity) and NOT invest in stocks and the like. We could earn a modest amount of interest in non-stock funds, the kind you buy when you're 72 years old, and we could sit on that interest for 10 years. Essentially, these IO loans could be very consumer friendly, and banks hated them for this reason. If anything, IO loans are more geared to benefit your average wage-earner than are the others.
So, now what's happened? The IO loans are being abused and are being given a bad name. Fear of economic collapse (on this site) has tainted what seem like the most consumer friendly loans on the market. While we spend our time ripping apart IO loans, our democratic leaders pass a bankruptcy bill which effectively inures companies like GMAC, some of the most predatory lenders imaginable. We lost that fight.
IO loans are a great idea for the middle class. But I'm afraid we're about to throw out the baby with the bathwater. They have been abused so badly that the trend is to press for their banning. If such a scenario ever came to pass, the banks would be very, very happy. They tried to suppress the interest-only concept for ages, until it was let out of the bottle. I recognize that the abuse of IO loans may already be so bad that we simply have to end what was once a great idea so that we don't have an economic collapse. that's a possibility. And it will be a shame if it comes to pass.
Finally, I'll give a brief breakdown for why I think the IO loan is a big benefit to a middle-class homeowner, or any homeowner who can otherwise afford a conventional loan. I remain of the firm belief that an IO loan should be an option for consumers, but if it's your only option when considering the purchase of a home, you're barking up the wrong tree.
My example of good IO loan:
If a home owner purchases a $300,000 home with a 5.5-6% fixed rate over 25 years, he or she builds equity in the amount of $74526 over those first 10 years.
If that same home owner purchases a home with an IO loan, then they pay approx. $655 in monthly payments less than the conventional mortgage home owner*. This $655 invested at 5% interest will yield a total of $129,493 after 10 years.
(
*The IO loan I'm using is pegged to LIBOR, which gives you about a 3% interest rate. If, in the next ten years, the LIBOR rate rises to 7-8%, you can figure out an average of say 5% for these variable loans. Right now the IO loans pegged to LIBOR have rates of 3%. So, if the LIBOR rates rise very fast in the next 10 years, you're probably still looking at an average rate of 5%. Historically, the LIBOR pegged rates have averaged 6.2% over the last 40 years, which includes the high interest 1970s and 80s. But with rates at the bottom of the curve right now, you have to adjust the average rate downward, even if you expect interest rates to skyrocket over the next decade. My numbers here EXPECT the LIBOR pegged interest rates to rise to 7-8%. The PRIME RATE when the LIBORs rise to 7-8% will be in the 9-10% range. So I'm accounting for a rise to 10% in the PRIME.)
So one homeowner has $74.5k equity in his house after 10 years. The other one has no equity in his house, but he has an additional $129.5k in cash.
If every middle class homeowner had such a loan, their annual incomes would increase by $5,950 over the next 10 years. That's almost $6,000 a year per homeowner that the bank isn't making.
I'm not even considering the higher tax deductions one takes by paying higher interest to the bank with an IO loan.
So there are compelling reasons to do it, as well as some risks. The risk is that you'll get greedy and invest in stocks or other risky investments. Also, after 10 years, if you can't make the mortgage payment, you never should have gotten involved at all. Lastly, I do leave open the possibility in some markets of using an IO loan when you can't get a conventional one. In my market in Buffalo, it makes sense. A one bedroom can cost you $800 in rent here, but you can also buy a 3,000 sq. foot house for $125,000. That's an IO payment of $270 a month. Even with property taxes, you are still well below rent.