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Interest-Only Mortgages, Popular in California, Raise the Stakes in Real
Estate
By MICHAEL LIEDTKE
The Associated Press
Jun. 6, 2005 - 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 the 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 like the San Francisco Bay area. Economou estimates he
saves $1,000 a month by having his interest-only mortgage instead of a
traditional 30-year fixed rate loan.
"I would 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 do not 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 home
owners. They are further elevating already lofty housing prices, a trend
that's raising fears of crash that could plunge the economy into a
recession.
"When this market adjusts, it's going to be painful," said UCLA economics
professor Edward Leamer, who has been warning of a California housing bubble
for three years. "Borrowers are getting in over their heads, and lenders are
too."
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,
they see homes as part of their investment portfolios in fact, a much better
bet than the stock market in recent years. In California alone, homeowner
equity has grown by a whopping $1 trillion since 2000, according to the
California Building Industry Association.
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 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 San Francisco Bay area,
where more than half of home buyers have financed their purchases with
interest-only loans since the end of 2003, according to LoanPerformance.
Large numbers of home buyers 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 an era dissected in his book,
"Irrational Exuberance," released in March 2000.
Shiller recently released a second edition with a new chapter warning 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 in an
interview. "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 many borrowers with homes worth less than
what they owe.
Also risky are the adjustable rates included with many interest-only
mortgages. If the prime lending rate continues to rise, these homeowners'
monthly payments could soar even as home values plummet.
A double whammy like that would increase the chances of borrowers falling
behind on their payments or, in the most extreme cases, just 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
during 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.
Interest-only mortgages have been a boon for buyers so far because home
values in most places have surged so much that borrowers are getting richer
on paper at least even as the amount owed on their loans remain the same.
For instance, the median sales price area of an existing single-family home
in the San Francisco Bay Area was $689,200 through the first three months of
this year, a gain of 45 percent from $475,900 at the end of 2001, according
to the National Association of Realtors.
Put another way, someone who bought a mid-priced Bay Area house with an
interest-only mortgage in 2001 conceivably could be sitting on a $213,300
gain in home equity enough to buy a house outright in many parts of the
country before repaying a cent of the original loan.
Economou, who is a commercial real estate broker, already is looking ahead
to mid-2007 when his loan will start to require principal payments. By then,
he hopes to have accumulated enough equity in his condo to be able to sell
it and to buy a bigger home.
"Of course, I'd hate to see my home's value drop significantly, but I
think this is a chance worth taking," Economou said. "It's been a pretty
good bet so far."
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Interest-Only Mortgages All the Craze
