When the Qualified Mortgage (QM) rule went into effect in early 2014, certain “risky loan features” were excluded by the Consumer Financial Protection Bureau (CFPB).
One of those features was an “interest-only” period, a fairly common attribute to mortgage loans worldwide.
Here in the United States, interest-only mortgages were basically the standard prior to the Great Recession.
No one really had any interest, no pun intended, in paying off their mortgages. Instead, they were happy to serially refinance and suck their home equity dry at the same time.
Some homeowners opted to go a step further and take out pay option arms, which allowed for negative amortization, which also happens to be banned under the QM rule.
Let’s learn more about them and discover why they were targeted by the CFPB.
How an Interest-Only Mortgage Works
A typical mortgage payment includes principal, interest, taxes, and insurance, otherwise known as PITI.
Each month, a portion of your overall payment goes toward the outstanding balance on the loan, known as principal, and a portion goes toward interest, which is collected by the bank or loan servicer.
Many mortgages are also escrowed, meaning a portion of property taxes and homeowners insurance is collected monthly, set aside in an escrow account, and paid out accordingly when due.
With an interest-only mortgage, the acronym shortens to ITI, as in itty bitty.
While it’s good for the homeowner, in the sense that their monthly outlay is lower, it’s bad in that their mortgage balance doesn’t change.
Each month, they simply pay the interest due, which doesn’t change if they only pay the interest. After all, if your loan amount and mortgage rate don’t change, neither will your monthly payment.
Let’s look at an example of an interest-only mortgage:
Loan amount: $300,000
Mortgage rate: 4%
Interest-only payment: $1,000.00
Fully-amortized payment: $1,432.25
As you can see, the borrower with the interest-only mortgage pays just $1,000 per month, more than 30% below the fully-amortized payment of $1,432.25.
While that lessens their payment burden each month, it does nothing to reduce their debt burden.
Each month, they’d owe $1,000, but their outstanding loan balance would remain at $300,000.
To make matters worse, the interest-only option is only typically available for the first 10 years of the loan term.
So in year 11, assuming it’s a 30-year loan, the homeowner would have to begin making fully-amortized payments. Alternatively, they could refinance their mortgage or sell the property.
If they couldn’t refinance/sell or decided to keep the mortgage, their monthly payment would skyrocket.
Instead of paying $1,000 per month, they’d owe $1,817.94 per month, nearly double what they had been paying.
Why? Because they still owe $300,000, but the remaining loan term is now just 20 years.
That amount must now be paid over 20 years instead of 30. This is what is referred to as “payment shock.”
Why Are Interest-Only Mortgages Banned Under the QM Rule?
As illustrated above, interest-only mortgages do nothing to reduce a homeowner’s debt. After a decade, the original loan balance remains.
This can result in massive payment shock once the interest-only period comes to an end.
Assuming the borrower is unable to refinance their mortgage and/or doesn’t want to (or can’t) sell their home, it can become a major problem.
After all, they might be able to afford a $1,000 monthly housing payment, but struggle with a payment of $1,800.
During the early 2000s, many of the homeowners who elected to take interest-only mortgages wound up in negative equity positions, where they owed more than their homes were worth.
This was the result of depreciating home prices combined with high-loan-to-value (LTV) mortgages, which meant it was impossible to refinance (or even sell) until the Home Affordable Refinance Program (HARP) came about.
Many homeowners simply walked away from the loss, instead of trying to reconcile the situation, knowing they owed far more than their property was worth.
And a good chunk of these borrowers couldn’t afford the payments regardless of the desire to stick around.
For these reasons, the CFPB felt it prudent to exclude interest-only mortgages from the QM definition.
They certainly don’t want us going down a similar path anytime soon.
Where Can I Get an Interest-Only Mortgage?
Now that you better understand how an interest-only mortgage works, and why they’re banned under the QM rule, you might be wondering where to get one?
Fortunately, they are still widely available from a variety of non-QM lenders. In fact, just about every lender that offers non-QM loans has them on the menu.
So you shouldn’t have much trouble finding one if you work with a lender that originates non-QM loans.
Just note that their underwriting guidelines may be more restrictive, and the mortgage rates will probably be higher.
Often, lenders charge a small fee for an interest-only option, which will either be reflected in the closing costs or the interest rate itself.
And the lender might limit the maximum DTI ratio, LTV, and require a large amount of assets for reserves.
Qualifying may also be more difficult, as lenders typically use the higher of the note rate (start rate) and the fully-indexed rate plus some margin.
In other words, you need to be a pretty good borrower these days to get an interest-only mortgage.
But don’t let that deter you if you’ve done your research and feel one of these products is a good fit for your situation.
While they aren’t QMs, interest-only mortgages are still readily available in today’s mortgage marketplace.
(flickr photo: Felix Burton)