How to Get an "F" in Home Economics

I never knew listening to the radio could be so harmful to my health. I had the dial tuned to a call -in show while in my car, and had to pull over I got so angry with what I heard.

Two absolute bozos hosting a show on mortgages--surprise, they just happen to own a huge mortgage lending company!-were giving out the most god-awful advice. As far as I am concerned this is the sort of crap the FTC should be concerned about: bad advice that causes folks to make absolutely terrible financial decisions that can screw them over big time.

Here's the gist of the horrendous advice:

Caller: I have a mortgage for $200,000 and my payments are $1,200 a month. My home is now worth $400,000.  I want to put the equity in my home to work for me so I can make more money.

Host: Here is what you can do.  You can take out ALL of the equity in your home with an interest only loan with a 1 percent interest rate. Rather than your payments being $1,200 a month- you will have to pay less than a $1,000 and you will still have $200,000 in your pocket to buy another piece of property.

Here's what Suze has to say: Are you all insane?? That is the most awful move anyone can make. The idiot hosts make it sound so easy, when what they are recommending creates huge risk for the homeowner. Here's what the hosts were leaving out of their advice: The going rate on a mortgage these days is about 6 percent. If someone is offering you 1 percent there's a catch. You don't really expect them to eat the five percentage point difference do you? And guess what, it's the homeowner who is eventually going to pay. At some point the 1 percent interest only loan is going to covert to a regular mortgage and that phantom 5 percent difference that seemed to magically disappear will essentially be added back into the remaining cost of the mortgage. Basically all you are doing is delaying having to pay the going rate...and that means you better be able to deal with the sticker shock when your mortgage converts and you get stuck with the much higher payments.

And please, don't try and fool yourself that it's okay to take out an interest-only loan today, because you will be able to refinance into a regular mortgage before your interest-only mortgage gets ugly. How can you be sure you will be able to refinance? What if interest rates rise over the next few years--a very real possibility by the way-so when you go to refinance you are going to have to pay a hell of a lot more than you would today if you had the sense to lock in a great 6 percent fixed rate loan. 

Listen to me: Do not listen to anyone who tells you an interest only loan is a good idea. It is insanity. As far as I am concerned, anyone who goes for an interest-only loan, whether it be for a primary mortgage or a refinance to tap equity, is about as smart as someone who blindly piled into tech stocks just before the internet bubble burst. And you are going to get just as burned.

Be smart: stay away from interest-only loans, and any so-called "expert" hawking them. They are financially toxic.

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Comments

[Michael]

Come on; don't sugar-coat the situation. How do you REALLY feel? :)

[Laura Gladney-Lemon]

You should write them a letter so they know. A boycott dosen't do any good unless a company knows they are being boycotted.

[sprmario]

It took a lot of explaining to keep my brother from getting into one of these interest only refinancings. His 30 mortgage is at 5.75% fixed. The problem w/ him is that he's an airline pilot and has taken a 40% paycut since 9/11. He's got a $300k mortgage on a $900k house (easily doubled since he bought at $425k). He also has a $65k HELOC that is maxed. I recommended he pay down the HELOC w/ the windfall and if he has to go into negative amortization to do so by drawing on the HELOC again. THere is no reason to put his entire mortgage into a variable interest only instrument when he can leave the bulk of it fixed at a very low rate and take on the interest rate exposure on just the HELOC portion. My point is that even if you want to get creative in your financings (and there are times to do that), there are ways to minimize your risk and achieve the same results.

[hp]

I agree with you. I was thinking in the same terms, but couple of friends say that to pay more towards primary mortgage ???

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[Anonymous]

I was trying to purchase a first home several months ago, and this sounds so much like the bad advice I was getting from the mortgage broker and buyer's agent I was working with.

The broker kept trying to push me into interest-only mortgages, and even into a reverse mortagage based on the fact that property was increasing at nearly $10K a month at the time.

The buyer's agent kept pushing the idea of getting a place and then just renting it out after a few months' appreciation in "equity", while purchasing a new place...despite the fact that rental prices in the area are no where near what the mortgage payment would have been.

I walked away.

More people should be "tuning out" this sort of crap, but interest-only mortgages account for more than 60% of the mortgages being processed where I live!

Scary.

[Bob]

To say "interest only" loans across the board are idiotic is idiotic in and of itself. I have a fixed interest rate only loan on my home with the option (a free one at that) to pay principal if I wish. The interest rate is NOT a "discounted" rate that gets added to my principal balance as Ms. Orman would have you believe is the case in ALL "interest only" loans. If you would like the luxury of of a "free option" to pay principal and interest it's there - if you choose not to pay all of your principal it's a mechanism that allows for more control over your monthly cash flow. Having read just a few of Ms. Orman's articles (and for sure the only ones I will read) her articles are highly colored with generalities and emotion that are best left on the floor of the editing office.

Bob

[pamela]

I find Bob's comments above quite hilarious.

First of all, it would seem that Bob believes that Suze is the only one warning of the inherent dangers of high risk home loans and mortgages, such as interest only loans and many ARM loans. Turn on the TV, read nearly any online article addressing the issue, or open any newspaper, Bob. The riskiness of these loans and the dangers they pose to many of those applying for such loans is the topic du jour. Suze is not the only one concerned with the increasing frequency at which such loans are being exercised, for most applicants, outside of the realm of financial common sense.

Most people are not applying for these types of loans because they are financial wizards who wish to free up money for other investment ventures and make payments towards their principal at their financial leisure. I would guess that most people with these types of loans are not making many, if any, payments towards their principal, regardless of their possible ability to do so under the provisions of their specific loan. They are selecting these loans because it is the only way they can get across the threshold of a home or because some agent or broker helped convince them to purchase beyond their means in order to boost their own commission.

While I appreciate that some people may be able to negotiate these types of loans to their financial benefit, though it is hard to imagine how, I am certain such cases are few and far between. If you are one of these such people, I offer my sincere congratulations and tip my hat to your financial sophistication. I would, however, wonder what you are doing on this blog, which is directed towards those trying to get their basic financial bearings, for whom interest only and ARM loans are almost certainly not a good idea.

[Rosalie]

I'm in the midst of making such a decision. I'm renting a cheap apt in LA but I'm tired of the apartment lifestyle. An interest only loan is the only way I can get it this home I found. I'm thinking of not going forward because of what I've been reading--but what then? Do I rent the rest of my life? What is an average, middle income mom supposed to do for her kids? We want a yard, garden and a real home. It is so hard when everyone else around owns...and I'm still renting at my age (48). Yet a 30-year fixed is way out of my monthly affordability. Why can't I just refinance after 5 years? Someone explain.

[pamela]

Hi Rosalie - you and others may find this article pertinent and informative.

http://www.msnbc.msn.com/id/8514801/

Hope it helps answer some questions.

[Mark]

"As far as I am concerned this is the sort of crap the FTC should be concerned about: bad advice that causes folks to make absolutely terrible financial decisions that can screw them over big time" Nice quote Suze considering if I had done exactly the opposite of your advice in the past I would probably have a 500k home and a few rental properties instead of sitting on the sidelines paying down my "safe" affordable 150k home. If only I would have followed my common sense.

[paul]

Suze advice goes in the same category as most QVC products that are pawned off at 19.95.
The reverse ARM or whatever it is called is an excellent financial risk managmement tool or as bob said gives you control over cash flow.
Always buy what you can afford (the 40% ratio or wahtever) The ARM options can be used to negate periods of unplanned finanical ditress like job loss etc. These option give you time to recover when used correctly. SuzieQVC needs to spend some time helping people understand these loans can help them succeed financailly in the long term. Perhaps the fact 60% of loans are of these types (interest only etc) is simply because people are allot smarter then SuzieQVC

[pamela]

Here's another really good article, Rosalie.

http://www.msnbc.msn.com/id/8574006/

[B Gill]

There is nothing wrong with interest only loans this days. In England 90% of all mortgages today are based on interest only. In the first 15 years (assuming 30 years mortgage) the chunk (90%) on a capital repayment mortgage goes towards servicing interest alone. Its only after 15 years the scales tilt when you start paying off a higher chunk in capital vs interest payment. This days who lives in the same house for 30 years...forget about passing it down....live cheap and ride on the equity build...screw the banks before they screw you!!!

[pamela]

And another article...

http://moneycentral.msn.com/content/P123681.asp

[Keith]

I watch the Suze Orman show often and have been reading the comments in this blog with some mild concern. I am a mortgage broker, so I have a little bit of insight in the matter of mortgages. I have heard Suze and others talk down about I/O and ARM loans for some time, as well read a comment from Pamela talking about how she wonders how people are able to make an I/O loan work for them. Here is a little information maybe you all will find informative, if not then make comments and I will answer them to best of my ability.

First I want to talk about I/O loans. If you are nervouse about the fact of only paying the interest then why not do a I/O 30yr note? The note is I/O for typically the first 10 yrs, then you start paying P&I for the remainder of the note. The interest rate is still locked for 30yrs like it is on a fixed loan, so the rate does not adjust. The good thing about an interest only loan is the fact that you are only obligated to pay the interest on the loan. You can always pay more. Now this is a good idea for all kinds of people, and here's why. say you are looking to purchase a $200,000 house. You put 20% down so the loan amount is $160,000. You are doing a 30yr I/O loan at 6%. Your I/O payment is $800 a month as opposed to $959.28 for P&I. You are saving $159.28 a month for ten years, that comes out to $19,113.60. Now you are able to get into a house you might not be able to otherwise qualify for because your DTI would have been too high. In ten years most people will be in a better situation then they are in now, as well as the fact that in the long run houses typically appreciate in value. So you now have a house worth more then you payed for it, and you are making more money so you can qualify for the loan easier because you have lowered your DTI. You can now refinance if the rates are as good or better, or keep your existing mortgage and the payments are now $1,146.29. Now if you want to use the I/O loan and make it work for you, you can do a couple of things with the $159.28 a month that you saved. First you could invest it. If you would have put that extra money into a mutual fund (it is not uncommon to find one with an average rate of return around 8%)you would now have turned that $19,113.60 that you would have paid toward principle into $29,493.19. You just made over $1,000 a year esentialy using the banks money. Now if you take that money and pay it all on your mortgage your monthly payment after the 10yr I/O period is now only $934.99 a month saving you $24.29 a month on what your payments would have been with a 30yr fixed mortgage. Another thing you could do is pay that initially saved $159.28 towards the principle every month. I wish I was at work now and could use the program I have, but essentially you would end up paying the loan off at the existing rate faster then if you just did a 30yr fixed.

Now about ARM's, they are a great way to get lower payments on your mortgage then by going with a 30yr fixed. The way an ARM works is like this: The rate is fixed for a set period of time, then it adjusts anually after that based upon what interest rates are doing. If rates are the same or lower they do not adjust your payment, if they are higher they adjust it according to the new rates up to the caps. Now the way caps work on an ARM is typically like this. It has a cap for the first increase, a cap for the second increase, and a life cap - meaning no matter what your rate can not go above that caped off rate. Take a 5% 5/1 ARM with 5/2/5 caps. What this loan means is that the most the rate can adjust to during its life time is an additional 5% or a total of 10% interest for the loan. Now it can adjust up to the maximum 5% increase based on how the rates are doing, again if they area better or the same it will not adjust. Then at the second adjustment it can only adjust 2% not to exceed a total adjustment on the first and second of 5%. Who is this loan good for? People who are looking to get into a home but plan on living there for only a few years then selling it.

Now I know someone is going to mention pre-payment penalties so I will adress them breifly. There are two types of pre-payment penalties, Hard and Soft. A hard penalty means that for a given leangth of time (typically 2-3 years) you will have to pay a percentage of the ballance to the lender if you pay it off early period, meaning if you refi., or sell it you will pay a penalty (typically 6% of the ballance with my lenders). A soft penalty allows you to sell the home with out paying a penalty. However if you refi. you will have to pay. Now you can also buy out your penalty when getting your loan. It will typically give you a slightly higher rate, or cost you money at closing depending on how you want to do it. Keep in mind that not all ARM's have a pre-payment penalty, it goes lender by lender.

Hopefully that little info will help you understand a few of the misconceptions about these types of loans.

[Tom]

B Gill & Keith, you make good points. But I think what Suze is getting at when she recommends that people stay away from I/O and ARM loans, is that:

1) Many people aren't responsible enough, or don't have the willpower necessary to invest that money they're saving on monthly payments. I'm responsible and I have excellent credit, but if I was seeing the extra money in my bank account, I'd want to go buy a bigscreen TV or new gadgets for my motorcycle. It's much easier to just put that money toward the conventional loan and not have to worry about it.

2) People TYPICALLY don't stay in a house more than 5 years, and people TYPICALLY make more money in 5 years, and houses TYPICALLY appreciate X% each year, and the Yankees TYPICALLY make the playoffs. The point is, you don't know what going to happen, no matter what's TYPICAL. What happens when in 5 years you can't qualify for a loan for a new house so you have to stay in your current one, because you were laid off or demoted, and the value of your house has been flat or gone down because the major industrial company in your town moved to Poland and property values went through the floor? Then that I/O or ARM doesn't look so good.

Yes, there are exceptions to every rule, but it sounds like Suze it telling us what's good or bad for most people. And there's a difference between someone who goes for a I/O loan because they see a way to make their money work for them, and someone who does the I/O because that's the only way to get into that "dream house." I think Suze is talking more to the 2nd person, and it makes sense that that person should stay away from I/O and ARMs.

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