Interest-only (I/O) loans do not fit into the Qualified Mortgage (QM) category. Therefore, if a lender were to originate a loan containing an I/O component, it would have to either keep it in portfolio or sell it to a private investor. Although not terribly common, interest-only loans are still available and, regardless as to whether the mortgage loan originator (MLO) offers them, all MLOs should be aware of what they are, how they work, and when they might present as the best solution to the applicant’s wants and needs.
Interest-only mortgage loans are not specific loan types, per se, rather they’re “overlays” applied to other, standard mortgages. For example, you may encounter or originate a 30-year, fixed, interest-only 15. This represents a 30-year, fixed-interest-rate loan with an interest-only component applicable for the loan’s first 15 years. Or how about a 5/1 ARM, I/O 10? This type of adjustable-rate mortgage would carry an interest rate that’s initially stable for the loan’s first five years, adjusts annually thereafter for the remainder of the 30-year term, and affords the borrower the option of remitting an interest-only payment for the loan’s first ten years, regardless of the interest rate applicable at any given time.
When a borrower selects a mortgage containing an interest-only component, although he or she is entitled to remit a periodic payment amount up to the loan’s remaining balance, the interest-only payment amount that he or she is required to remit satisfies only the interest due. No part of an interest-only payment is applied against the loan’s principal balance. Therefore, and for as long as the borrower remits the interest-only payment amount, his or her loan balance remains the same.
Why would someone select a loan containing an interest-only component? Well, incurring a lower periodic payment amount comes to mind. Affordability, however, should never be a motivator for pursuing an interest-only loan. Since the borrower’s mortgage payment will likely and significantly increase at the conclusion of the loan’s interest-only period, if, for any reason, the borrower was unable to accommodate that payment amount, he or she could find him or herself in a world of trouble. Therefore, anyone who considers a loan containing an interest-only component should be ready, willing, and able to accommodate the loan’s worst-case scenario. In fact, in order to qualify for an interest-only loan, the applicant would have to be able to qualify at the worst-case scenario payment amount.
Consider the following example. A borrower selects a 30-year-fixed, interest-only 15 loan option for $200,000 at 6%. The fully-amortizing payment amount associated with this loan would be $1,199.10. Since this loan contained a 15-year interest-only component, however, the borrower would be fully compliant by simply remitting the interest-only payment of $1,000. By doing this, the borrower would save $199.10 per month but their mortgage balance would remain the same.
Fast-forward 15 years. With the interest-only component expiring, the borrower’s outstanding loan balance is still $200,000 (assuming that he or she only remitted the interest-only payment) but the loan’s term is now 15 years. As such, this borrower’s payment increases to $1,687.71. Consequently, the borrower would had to have demonstrated the ability to repay the loan based on the $1,687.71 payment amount when initially applying.
Since affordability cannot be a factor when considering an interest-only loan, why would someone pursue one? The interest-only solution best serves the borrower who can qualify at the worst-case-scenario payment but:
- Desires a consistent income tax deduction; and/or
- Wants to build savings
Income Tax Deduction
Let me be noticeably clear. Unless you are a certified tax advisor, never provide definitive tax advice or guidance. Even though you may be generally correct, providing even the slightest bit of incorrect information could leave you vulnerable to accusations of malpractice or possibly operating as a tax advisor or accountant without a license. Even if you believe that you are correct, always preface any tax-related advice that you offer by clarifying that what you’re advising is most likely accurate and that he or she would be best served by consulting with a certified tax professional or the Internal Revenue Service (IRS).
Assuming that interest spent through a mortgage is tax deductible, by only remitting the periodic interest due and not reducing their loan’s balance, the borrower would theoretically be able to deduct the same amount of interest spent every year versus lower amounts annually as the mortgage’s balance reduces.
Imagine a customer owns a home worth $2,000,000. He currently owes $500,000 and plans to sell in fifteen years. In discussing mortgage options, you discover that the borrower’s “pain point” is a lack of savings. He simply has no reserves on which to fall back. He’s perfectly comfortable remitting a 30-year, fully-amortizing payment amount but has little beyond that to dedicate to savings.
The interest-only loan may be this borrower’s perfect solution. Since he is not at all concerned with increasing his equity position and, since he can easily remit the 30-year, fully-amortizing payment amount, you suggest a 30-year-fixed, I/O 15 loan option. Here is how this works.
You offer him a loan amount of $507,000 to include settlement costs. Assuming a fixed interest rate of 5.5%, he should be completely comfortable with remitting the fully-amortizing payment amount of $2,878.69 every month. Since the monthly interest-only payment amount due to the servicer is $2,323.75, this is the amount that he will remit. He immediately deposits the $554.94 difference into a savings account. As long as the borrower does this every single month, by the end of the loan’s 15-year interest-only term, when he’s ready to sell the home, for spending no more than the fully-amortizing payment amount, he has amassed $99,889.20 (554.94 x 180) plus interest.
Since “life happens,” however, if he was unable or unwilling to sell the property at this time while also being unable to refinance, he would have to be able to accommodate a new, fully-amortizing payment amount of $4,142.61 since his loan’s balance would still be $507,000 but would then be based on a remaining 15-year term. Because this would be a distinct possibility, at the time of application, the payment amount for which he would have to have qualified would not have been the 30-year, fully-amortizing payment amount of $2,878.69 rather the worst-case scenario payment amount of $4,142.61.
Mortgage loans containing interest-only components are exceptional options for those whose needs involve potentially maximizing interest deductibility and/or amassing savings. These loan types should never be used to accommodate borrowers who are otherwise unable to afford a fully-amortizing payment amount. Armed with the knowledge of how the interest-only loan solution works, the successful mortgage loan originator is best able to appropriately advise, counsel, and guide his or her customers.