Interest-only adjustable rate mortgages (ARMs) are back — and this time lenders swear they’ve changed their behavior.
New qualification measures are in place to ensure interest-only ARMs are only awarded to homebuyers who are able to meet future payment schedules once monthly payments increase to start the amortization of principal. Originations will not be based on the initial teaser rate of interest-only payments as a percent of income.
Qualifications for interest-only mortgages now include:
- a minimum 20% down payment;
- a minimum FICO score of 720;
- the ability to afford the monthly payments on the eventual amortization of principal; and
- a debt-to-income ratio (DTI) which may not exceed 42% throughout the life of the mortgage.
Requirements like these allegedly make interest-only lending a safe practice, according to optimistic lenders like United Wholesale Mortgage (UWM) and Wells Fargo. Long-term criteria used to determine qualified homebuyers are intended to structure interest-only ARMs as a suitable alternative to the Consumer Financial Protection Bureau (CFPB)’s qualified mortgages.
Interest-only ARMs begin with low payment rates and payment schedules, which adjust upwards with interest rates as current rates change during the interest-only payment period. The interest-only payment period usually lasts about five to ten years. Depending on the ARM terms, interest rates may increase as frequently as once per month during this period. After the interest-only payment period, principal is amortized resulting in a further increase in monthly payments for the remainder of the mortgage term.
Unlike a standard adjustable rate mortgage (ARM), interest-only ARM payments do not increase solely due to changes in interest rates. Instead, payments increase on commencement of principal amortization after the interest-only period. Amortization may cause payments to double or triple from the initial low monthly payments, even if the interest rate does not change.
Interest-only ARMs wrought havoc in the housing crash
Interest-only ARMs were widely used and abused in the years leading to the housing crash. Homebuyers bought larger homes for smaller down payments and less in monthly payments, believing themselves in perfect financial condition to handle the deferred principal debt reduction on interest-only ARMs. Lenders were willing and eager accomplices, ushering homebuyers into non-amortizing mortgage arrangements. When the market crashed, followed by the employment market and the 2008 Great Recession, homebuyers suddenly found themselves shackled to negative equity homes.
Additionally, significant decreases in home values led to total despair for homebuyers when the eventual amortization of principal began. With no equity in their homes, homebuyers were stuck with payments greatly exceeding their homes’ rental value and wallets’ girth. This led to widespread personal insolvency. Short sales and foreclosures dominated the resale market, condemning interest-only mortgages to a historical Pandora’s Box of risky lending practices – or so we thought.
Lending to savvy homebuyers
Interest-only ARMs are not qualified mortgages available for purchase by Fannie Mae or Freddie Mac on the secondary mortgage market. Instead, UWM underwrites interest-only ARMs originated through mortgage brokers, small banks and local credit unions, then sells these mortgages to Wall Street firms, who in turn bundle the mortgages and issue bonds to private investors.
Thus, interest-only ARMs come with non-conforming risks of an inability to quickly sell them in the secondary mortgage market if the lender retains the mortgage. As long as wage recovery remains slow – the sharing of America’s productive wealth – the average homebuyer will not be legitimately included in the sweep of candidates for an interest-only ARM.
Instead, UWM claims interest-only mortgages will be wise investments when originated with the right buyers, deemed “savvy” homebuyers: those with hefty paychecks who meet the requirements and prefer to use an interest-only ARM as a means of financial management. The analysis includes subsidies via income tax avoidance.
Still, homebuyers have the option to refinance interest-only ARMs at any time (so long as property values don’t plunge underwater as they did during the Great Recession). Refinancing the mortgage before principal is added to the payments may help to negate the potential for interest-only mortgages to destabilize the housing industry as they did before, but refinancing is costly. However, on a new 30-year fixed rate mortgage (FRM), the monthly payments will be less than payments on an interest-only ARM when amortization kicks in.
Agents and brokers need to be cautious with interest-only mortgages and counsel their buyers about the risks they present. Unless advised by their agent, some short-sighted homebuyers may view the prospect of low monthly payments as advantageous and sign hastily on the dotted line. The danger is in their ignorance of the magnitude of future payment hikes brought on by interest rate adjustments and principal amortization. Homebuyers also need to be informed that interest-only ARMs, by their very nature, cram amortization into a shorter time period, since the first several years of the mortgage term do not include principal reduction.
Discretion is critical to avoiding the same disastrous effects interest-only mortgages had a decade ago. Even with lenders’ newly promised precautions, interest-only ARMs are not for the faint of heart – or the typical homebuyer. Unlike the past 30 years, the next few decades will see interest rates on ARMs rise, with payment schedules in tow.
Re: “Interest-only mortgages: They’re baaack,” from CNBC