Exotic Financing Fans Fire

Excerpted from Money Magazine:

The rub is that fewer and fewer San Diegans have a standard mortgage. According to PMI Mortgage Insurance Co., more than two-thirds of the loans to buy homes here last year were interest-only mortgages, which have much lower monthly payments but much bigger bills to pay down the road.

San Diego home prices have risen 138% in the last 5 years, while incomes have gone up about 1% a year according to Office of Federal Housing Enterprise Oversight. This translates into only 11% of the population of San Diego being able to afford a median priced home on a conventional 30-year fixed mortgage. The result is that people are using interest only mortgages to "bet" on their homes increasing in value. This is a great bet as long as housing prices continue to rise, but watch out if they flatten out our fall.

INTEREST ONLY DANGERS:

1. Interest Adjustment
At the end of the initial 3,5,7 year interest only period the interest rates automatically adjusts to a market rate. These adjustable rates are indexed off the short end of the curve where it is safe to assume the Fed will continue tightening.

2. Principal Payments
At the end of the interest only period, the borrower must begin repaying principal, which instantly increases the monthly payment no matter where interest rates are, and is not tax-deductible.

3. Shorter Amortization Schedule
The principal must for 3,5,7 year interest only loans must repaid on a 27,25,23 year respectively amortization schedule. Shorter schedule means larger payments.

Of course, one can always refinance the loan into a fixed rate at the end of the interest only period to avoid these pitfalls. However, the majority of people utilized interest only instruments because they could not afford the house in the first place on a conventional fixed rate loan. And with incomes only increasing 2-3% annually it is doubtful that in 3-5 years they will be able to afford significantly higher payments to qualify for fixed rate mortgages.

The next, best hope for people in interest only loans whose payments are skyrocketing is to refinance into another interest only loan. Of course, they have paid down no principal in the preceding time period so the loan amount will be the same. As well, the Fed has made it very clear that short term rates are going to rise, which will increase the cost of borrowing dramatically. For instance, if you have a $500k interest only loan that was borrowed at last year's record lows of 4%, then you make monthly payments of $1,666. Assuming that short term interest rise another 100 bps by the time you need to refinance in 3 years your monthly payment will be $2083 or an increase of 25%.

The final hope will be for many of these interest only borrowers to sell to capture the equity and payoff their loans. The question is, if they all start selling at the same time, from 2006-2009, will there be enough buyers to afford these homes at higher interest rates?

The Sirens are enchanting many a home owner to become a "home investor" in California. But investors need to remember there is never a sure thing. If we are blinded by the beauty of gain we cannot see the perils of loss.