Interest-First Mortgages Grow in Popularity among Homebuyers and Lenders

Charlie Mac
August 8, 2005

Early in this decade, the low-rate environment heated up mortgage lending for all financial institutions, including credit unions. In 2003, mortgage originations topped $3 trillion, with the bulk of those refinances. And last year, with consumers rushing to buy or refinance their homes while interest rates were still appealing, homeownership in this country reached a record high of 69 percent. But since rates began to rise in mid-year 2004, mortgage lending has become a little more of a balancing act.

Projections for the 2005 mortgage market continue to be healthy, but expectations are for mortgages to be closer to $2 trillion this year, most of them purchases. Further, consumers are becoming more savvy in understanding the choices available to them for financing their homes. So, in today’s environment, the No. 1 opportunity and challenge for credit unions, whose share of this market is only 3 percent, is to find creative ways to meet members’ borrowing needs. One increasingly attractive option: interest-first mortgages.

Homebuyers often find interest-first mortgages a smart choice because their structure initially allows monthly payments to be considerably lower than more conventional loans. Traditional mortgages typically require payment of principal and interest throughout the term of the loan; but with an interest-first mortgage, the borrower pays only the monthly interest for a fixed number of months. Then, when the initial term expires (usually between 3 and 10 years), the monthly payment increases as the mortgage fully amortizes over the remaining life of the loan. Interest-first mortgage products are offered on both adjustable- and fixed-rate mortgages. Typically, interest-first mortgages don’t run the full term of the loan because borrowers tend to refinance when the interest-first term ends. That’s true even with fixed-rate loans.

Interest-first mortgages were initially created for streetwise investors who wanted to take advantage of operating on “other people’s money” for other investment purposes. But now, interest-first mortgages and their resulting lower initial payments are quickly becoming popular among a much larger market of borrowers. According to a just-out report by the Harvard University Joint Center for Housing Studies, “State of the Nation’s Housing 2005,” as many as a third of the home-purchase loans originated in 2004 were interest-only. In areas of the country where home prices continue to rise dramatically, such as the Northeast, Southeast and Southwest, buyers find interest-first mortgages to be a very desirable option. That’s been especially true, the Joint Center’s study says, in the “pricey metros of California, where the ratio of median house prices to median household income tops out at over 9 to 1.”

Here’s an example of the advantage of an interest-first mortgage to a home buyer: On a 30-year, fixed-rate amortizing loan of $500,000 at 6.5 percent, the monthly payment would be $3,160. But with an interest-first loan, the monthly payment would be $2,708 for the initial term – a monthly savings of $452. Another member benefit, particularly in high-growth areas, is the considerable equity being built by market appreciation.

As with any type of mortgage, it is important to help your members understand how interest-first mortgages work and to caution them about the potential for “payment shock” when the loan terms change to include paying principal. But economists expect to see consumers demand for this type of mortgage grow as a way to offset rising rates and escalating home prices. Including interest-first loans in your product mix alongside standard fixed- and adjustable-rate mortgages offers benefits all around. You can help your members realize the dream of first-time homeownership or expand their options as their family needs grow. And you can equip your credit union with another way to succeed in the competitive mortgage market.

Charlie Mac is a credit union-only secondary market investor that works with corporate credit unions to provide an outlet to credit unions for jumbo mortgage loans, including interest-first mortgages. For more information on Charlie Mac, contact your corporate credit union or visitwww.charliemac.org.