Interest-only, zero-down loans have risks

By Sue McAllister
Knight Ridder News Service

If mortgages can be fashionable, then so-called "interest-only" and "zero-down" loans are the trendy way to borrow right now.

But beware. These loans are not right for everyone. Here's a quick look at interest-only and zero-down loans, along with their advantages and disadvantages.

Typically an interest-only loan is an adjustable-rate mortgage with a 30-year term, but with an introductory period — five or seven years, for example — during which borrowers are required to pay only the interest that the principal is accruing. Not all interest-only loans have a fixed rate during the interest-only payment period.

At the end of the interest-only period, payments will rise, as the principal is amortized over the remaining term of the loan (25 years, for example). On most loans, the interest rate adjusts annually.

For a $500,000 loan at 5.25 percent during a seven-year interest-only period, the monthly payment is $2,188.

For a $500,000 fixed-rate loan at 5.25 percent interest in which the borrower pays both principal and interest, the monthly payment for the full term of the loan is $2,761.

Advantages:

• Lower monthly costs than almost any principal-and-interest mortgage. Can be a good choice for people who need or want to reserve some cash.

• Allows borrowers to qualify for bigger mortgages. The lender approves your loan based on your ability to afford the monthly payment. So, if you can afford about $2,000 a month, that might get you a traditional fixed-rate mortgage of $335,000 at 6 percent, or an interest-only mortgage of $400,000 at 6 percent.

• Borrowers can pay up to 20 percent of their principal annually without penalty. That's helpful to those whose income fluctuates during the year, for example those paid on commission.

• Potentially a good choice for buyers who plan to sell or refinance before the interest-only period ends and their payments go up steeply.

"Bottom line, it allows a consumer to qualify for more mortgage, and it also provides an avenue for flexibility," said Nino Saso, branch manager of Pacific Republic Mortgage in San Jose, Calif.

Disadvantages:

• Monthly payments will rise dramatically after the interest-only period ends and will depend on prevailing interest rates. If you are unable to refinance the loan and don't plan to sell the home, the resulting payments might not be affordable.

• Poor choice for borrowers who want to know exactly what their payments will be after the initial interest-only period.

"If you're risk-averse you're not going to like this program at all," said Nigel Cooper, a mortgage loan consultant at Meriwest Credit Union in San Jose.

• Poor choice for borrowers whose goal is to gain equity by paying down their principal.

A zero-down loan allows a buyer to purchase a home without committing any money as a down payment.

Thus, if you buy a condo for $400,000, your mortgage will be for $400,000.

However, you will have to pay for loan closing costs — typically a few thousand dollars for such things as title insurance and loan fees.

Lenders also will require that you have at least a few months worth of reserves — money in the bank, or in certain types of retirement accounts or investments — that would allow you to pay your mortgage in the event you lose your job, said Scott Larson of Chase Manhattan Mortgage in Campbell.

Advantages:

• Allows a buyer with little savings but sufficient income and credit to purchase a home. This option often appeals to younger people and first-time buyers, said Cooper of Meriwest.

When home prices are rising, they often outstrip people's ability to save for a down payment. But by buying a home for no money down, buyers can start building equity quickly.

That's what Mathew and Megan Haugen of Half Moon Bay, Calif., did when they bought a townhome in December for $480,000 with a zero-down loan.

"In the past five months, we've seen a 10 percent increase in the value of our home," said Mathew Haugen, 30, a salesman with an Internet ad firm.

Disadvantages:

• Generally speaking, if you put down less than 10 percent toward your home purchase, your lender will require you to pay for private mortgage insurance, or PMI. PMI can add thousands of dollars to your homeownership costs over the first few years of your loan.

• Interest rates for zero-down loans are typically slightly higher because of the increased risk that the borrower will default.

• If you unexpectedly need to sell your home soon after you buy, you may have gained little equity in the home, and will have to pay closing costs and any real estate sales commissions out of your own pocket.