Have you ever heard of an interest-only mortgage? If not, you aren’t alone. Interest-only mortgages are pretty rare these days. They were not so rare back in the 1990s and early 2000s. They were so common back then that lenders were advertising them on TV, radio, and in newspapers and magazines. These days, not so much.
Although you could find an interest-only mortgage if you looked long and hard enough, banks are very reluctant to offer them nowadays due to the lingering effects of the 2007-2008 housing crash and financial crisis.
Interest-only mortgages were not the sole cause of the crisis. However, they were a very big contributor to it. Too many banks making too many interest-only mortgages created instability in both the financial and property markets.
Eventually, both markets took a huge tumble. More than a decade later, banks are still shying away from interest-only mortgages.
How Such Mortgages Work
Interest-only mortgages come in numerous flavors. The one thing they all have in common is lower monthly payments at the onset. For a certain amount of time, the borrower does not pay any principle. Only interest payments are made. At some point though, the principle comes due. That is where the differences lie.
In a traditional interest-only scenario, the mortgage is actually a balloon mortgage. Interest payments are made for 7-10 years. On the loan’s maturity date, the entire principle is due. It is paid with a single balloon payment.
The balloon mortgage model is extremely rare today. The few interest-only mortgages that do exist tend to be 30-year notes with interest-only payments terminating after a short amount of time. For example, a borrower may pay interest only for the first 5 years. Beginning in year 6, he starts paying both interest and principle.
Interest-Only Loans in Hard Money
There is a niche industry within financial services that still utilizes the interest-only loan concept. We are talking hard money here. Hard money lending is private lending originating from companies or fund managers whose financing comes from investors. Salt Lake City’s Actium Partners is an example of a typical hard money lender.
Actium lends mostly for real estate transactions. They help commercial real estate investors acquire properties with short term loans that are typically paid off within 6-24 months. Some of those loans are structured as interest-only loans. The borrower makes regular interest payments followed by a balloon payment on or before the loan’s due date.
Hard money lenders are more open to the interest-only concept because they loan based on assets rather than the borrower’s full faith and credit. A loan obtained to purchase a new piece of property would be backed by said property. The property would be offered as collateral on the loan. A combination of high value, high liquidity, and a substantial downpayment mitigate the lender’s risks considerably. With lower risk comes a greater willingness among lenders to write interest-only loans.
Not a Good Idea for Mortgages
Interest-only loans work fairly well in the hard money game. The way hard money lending is structured allows lenders to offer interest-only loans with minimal risk. The same is not true in the residential mortgage market. Simply put, interest-only loans are not a good idea for home mortgages.
Banks and credit unions assume too much risk on interest-only loans. That’s why they are so rare these days, at least compared to 30 years ago. Back then, banks took more risks in order to help consumers buy houses. But they learned a hard lesson from the crash. It is a lesson that now causes them to shy away from interest-only loans.