The qualified mortgage rules that the federal government instituted in January to create safer loans has eliminated many interest-only loans, mortgage experts say, but not all of them.
They're not "less prevalent, less available and also harder to qualify for," says Cyndee Kendall, vice president and regional sales manager at Bank of the West's Northern California division.
Originally created for the real estate investor to hang on to a larger amount of cash for additional investments, interest-only loans were in vogue for the general public from the late 1990s to the early 2000s as an attractive option for buying a home, says Ellen Davis, a senior mortgage lender at Corridor Mortgage Group in Columbia, Md.
Unfortunately, most consumers weren't educated on the best use of interest-only loans or how to use them to their full potential, Davis says.
How an interest-only loan works
As its name suggests, only the interest is paid on the principal balance for a set term, usually three to five years, but sometimes as long as 10 years. The principal balance remains unchanged. At the end of the interest-only term the borrower may extend it into another such loan, pay the principal, or convert it to a principal and interest payment.
When the interest-only payment ends after the typical three to five years, borrowers would have "payment shock," Kendall says. The interest-only loans were an adjustable rate mortgage, or ARM, and lenders could extend the loans to five-year to 10-year ARMs, she says.
After the interest-only period, the principal is amortized for the remaining term - meaning the homeowner is paying the principal over a shorter term and would have larger monthly payments. For example, by not paying on the principal balance for five years while paying the interest only on a $250,000 loan, the borrower would have lower mortgage payments during the first five years but would have higher payments afterward.
"They're setting themselves up for a different payment down the road," Kendall says.
Interest rates on interest-only loans are about a third higher than a conventional mortgage, Kendall says, because they're a higher risk for lenders.
Who would want one
For someone who wants their money for cash flow so they can invest it elsewhere, an interest-only loan can make sense. It can also help someone who is only paid a few times a year on commission, or expects to have a substantial salary increase in the coming years.
"It's a way to utilize your money for other purposes" such as paying off debt, funding retirement or having money available for investments, Kendall says.
"For the most part, interest-only loans have returned to the domain of the private wealth client," says Brian Koss, executive vice president of Mortgage Network in Danvers, Mass. "These are qualified individuals who are deemed sophisticated and wealthy enough to take the risk, since they generally have enough assets to cover any increase in payments."
"Lenders are comfortable that these people know what they are doing and can handle the pain if they are wrong," Koss says.
Interest-only loans are also popular for construction loans, an equity line, and among the affluent who can afford to pay off the mortgage entirely if they need to while using the loan as a way to better manage their money.
Downsides are that interest-only loans allowed borrowers to buy more home than they could afford, and market conditions could hurt them more because they aren't building equity in the house during the interest-only period.
The Qualified Mortgage (QM) and the Ability-to-Repay rules mandated by the Dodd-Frank Act took effect Jan. 10 and prohibited "toxic" loan features such as interest-only loans for QM loans. Lenders that make QM loans receive some degree of protection against borrower lawsuits.
Still available, but tougher to get
Some banks still offer them as non-QM loans, with stricter requirements.
Bank of the West, for example, offers interest-only loans under the same qualifying terms as it does other non-QM loans, Kendall says. That includes having a low debt-to-income ratio of 43 percent or less.
The bank also ensures the borrower can afford the payments at the end of the five-year ARM, for example, which can be up to 5 percentage points higher than a traditional loan, she says.
A higher income isn't necessary, she says, though it may help them have the required three years of payments in reserves. Bank of the West's approach to making interest-only loans is assessing the ability to repay, Kendall says.
Wells Fargo, the biggest residential lender in the country, has stopped offering most customers the interest-only version of its home-equity line of credit. Customers can still get the interest-only option if they have significant assets and show they can afford a bigger bill when the principal is due.
Only a handful of private banks offer interest-only mortgages, and their requirements vary greatly, Koss says. "There is some flexibility among them, but generally speaking, these banks have to document everything," he says.
Borrowers should be prepared to meet the same standard as Fannie Mae' guidelines for interest-only loans, he says, including a maximum loan-to-value ratio of 70 percent, a credit score of 720 or higher and a minimum of two years of reserve assets after the loan closes.
"A private bank may offer borrowers something better, but borrowers should keep in mind that easier terms often come at a higher cost," Koss says.