Tuesday, March 10, 2009

Interest-only Mortgages by Another Name

After all the carnage in the mortgage industry over the past few years, I am still amazed that many in the financial services industry still do not understand the number gimmicks that led to the mess. An op-ed piece published in the February 27, 2009 Baltimore Sun by Sim B. Sitkin a professor of management at Duke University, advocated extending mortgages to 50 or even 100 years as a way to make houses more “affordable.” That sounds like an impressive proposal for lowering monthly payments. However, whether the mortgage term is for 50, 100 or even 1000 years, monthly payments can never fall to an amount less than the interest due on the first month of the loan. In the limit of extremely long loan terms, the loan effectively becomes an interest-only agreement.

Of course Mr. Sitkin didn’t use "interest-only" as a descriptor. That label now has a negative connotation given the millions of homeowners with interest-only loans currently underwater because home prices went down while their debt did not. But lets look at how much 50 and 100-year loans differ from interest only loans. I’ve constructed tables below with some examples. Scroll down to view the tables.

30-Year $200,000 loan5%7%9%
Monthly Payment $1073 $1330 $1609
Interest paid in the first month $833 $1166 $1500
Principal paid in the first month $240 $164 $109
Time to pay 10% of loan (years)67.79.6

50-Year $200,000 loan5%7%9%
Monthly Payment $908 $1203 $1517
Interest paid in the first month $833 $1166 $1500
Principal paid in the first month $75 $37 $17
Time to pay 10% of loan (years)15 20.5 25.4

100-Year $200,000 loan5%7%9%
Monthly Payment $839.04 $1167.75 $1500.19
Interest paid in the first month $833.33 $1166.66 $1500
Principal paid in the first month $5.71 $1.09 $0.19
Time to pay 10% of loan (years)5567.274.4

Here are some numerical facts from these tables.

First note that a 100-year mortgage proposed by Mr. Sitkin is for all practical purposes an interest-only loan. No significant debt reduction will take place in the borrower’s lifetime.

Second any advantages that a 50-year loan would have over a 30-year loan in reducing monthly payments diminishes at higher interest rates. The difference in monthly payments been a 30-year and 50-year mortgage decreases as interest rates increase. Also the amount allocated towards principal in the early years of the mortgage becomes less for both 30 and 50-year loans at higher interest rates.

Mr. Sitkin used 5% as an example interest rate. However, I pointed out in a letter to the editor that the Baltimore Sun published that “to get a lender to commit to so long a loan would probably require paying a higher rate than the historically low 5 percent mortgage rate used in the example. In that case, the numbers get much worse for the borrower.”

My published letter provoked a response from Mr. Richard T. Webb, CEO of Atlantic Financial Federal Credit Union, that the Baltimore Sun published on March 8. In his letter he made two statements I find puzzling. In response to my assertion that interest rates would be higher for a 50-year loan compared to a 30-year loan he wrote:

“And from the point of view of the lending institution, I'd rather own a long-term 5 percent loan than have a bankruptcy judge cram down a mortgage payment.”

This prompted me to check the loan rate page on his credit union’s Website. I found the same pattern for interest rates on that page that I find at every other financial institution—the longer the loan’s term the high the interest rate. On the Baltimore Sun’s business page today, the average rate for 15-year mortgages rate is 4.76% and for 30-year mortgages 5.17%. Although those numbers fluctuate daily, every single day the 30-year rate is greater than the 15-year rate. I have no reason to believe that the pattern of higher rates for longer loans would not continue for loan terms beyond 30 years.

The other puzzling assertion he made is that I failed “to consider the length of time most homeowners keep a mortgage.” He wrote:

“It's highly unusual for a homeowner to keep a mortgage for 30 years. The average time a mortgage is held is around seven to nine years. Extending the repayment period would achieve the desired effect of reducing the monthly mortgage payment. Wouldn't it make sense to be making smaller payments on a longer-term loan when the chances of staying in a house for 30 years are small?”

But isn’t that the reason why a homebuyer should avoid a 50-year loan? Again look at the numbers in my table above. Homebuyers who don’t pay down debt are at the whim of the market when it comes to refinancing or selling. If home prices rise they can sell or refinance. But, if prices fall homeowners have negative equity. No bank or lending institution will finance a home with negative equity. If rates fall, homeowners cannot refinance to take advantage of the lower rate for homes with negative equity.

Events of the past few years have shown that the assumption that home prices can only rise over time is false. But financial institutions are still dispensing advice based on that underlying assumption.

I still stand by my concluding paragraph in my letter to the Sun. Focusing only on monthly payments with no long-term plan for paying down the debt is one of the root causes of the housing crisis. Homebuyers would be better served with monthly payments that allow them to build equity, even if it means scaling down or deferring their homebuying choices.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

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