The days of fogging up a mirror to get a home loan are over, but one remnant of that era of only five years ago will soon be gone: interest-only loans.
Interest-only mortgages won't meet new federal standards to be classified as qualified mortgages under new rules that take effect Jan. 10, 2014. The cutoff for applying for such loans is mid-November. The coming standards require Fannie Mae and Freddie Mac to only acquire loans that meet the qualified mortgage, or QM, definition - an extra layer of legal protection for the lender based on the borrower's ability to repay.
Interest-only loans are just what the name implies - paying only the interest on a loan for 10 years, when the principal must begin to be paid. For people who don't plan on staying in a home for long time, or have fluctuating incomes, they can help make a better home more affordable.
A bad reputation
But when combined with other factors that helped lead to the housing crisis and recession five years ago - such as getting home loans without income or asset verification, and 100% financing - interest-only loans have gotten a bad name.
"The perception among the public is that interest-only loans are not a good idea," says Matt Hackett, operations manager and underwriting manager at Equity Now, a New York-based direct mortgage lender.
Such loans have decreased lately as lending standards have tightened, according to the Mortgage Bankers Association. The Mortgage Credit Availability Index, which the MBA uses to measure mortgage credit, dropped 0.7% in August, the first drop following four consecutive months of increases.
The fall was "driven by decreases in availability of loans that have an interest-only feature," the MBA found, along with lenders stopping offers of loans with terms greater than 30 years.
Who wants interest-only loans?
A typical customer is someone with a low base salary but who earns high annual bonuses, such as a Wall Street broker, says Michael Moskowitz, president of Equity Now. They could afford the low interest-only payments with their salary, and could make bigger payments to pay off the principal when they get a bonus, he said.
They're not a good idea for someone on a fixed income, he says, but are thought to be safe for someone with a steady, high income. But for someone with an expected high income many years after graduating from college who wants lower house payments because they're just out of school and paying off student loans, such as a doctor, an interest-only loan could help them afford a bigger house, Moskowitz says.
They're not suitable for people buying a home for the first time, have fluctuating income, have low equity in their property, have seasonal income, or could end up with an underwater loan, says Stew Larsen, executive director of mortgage banking at Bank of the West.
They can be good for home buyers paying college loans, or for people with unforseen bills.
Kevin Smitts, a real estate agent with Century 21 in Summit County, Colo., says he was happy to obtain an interest-only home loan because it allowed his family to live in a neighborhood they couldn't qualify for with a conventional mortgage.
They bought a home at auction and knew the value would increase, and got a lower interest rate when the conventional rate was 8.5%.
The downside is that the principal isn't lowered unless the borrower is disciplined enough to send in extra money, and if you don't buy the right house that appreciates in value, you can end up upside down in a hurry.
Some interest-only loans may still be sold
For some people, interest-only loans are worth getting, and they can still get them if a lender decides to do non-QM loans, Larsen says. The borrower will need to have a stable income and high FICO credit score, and if they're refinancing a home loan, they'll need to have a lot of equity, he says.
"We don't steer people to these loans," he says, though the bank doesn't think they're bad loans and says that some customers want the loans. Bank of the West is still determining if it will continue offering interest-only, non-QM loans, which require the buyer to show an ability to repay and fully documenting income and other loan factors.
"The real test is being able to properly document," Larsen says. "In many ways, this is going back to the way we used to do mortgage lending."
"If it's not right for you, chances are you won't qualify anyway," he says.
Hackett, from the mortgage lending company, says his business isn't getting many inquiries now for interest-only loans, partly because of the bad reputation the loans have, but also because borrowers don't want to take such risks.
"I don't think people are getting them now," he says of interest-only loans throughout the mortgage industry. "People are getting much more conservative."