Peace On That

I was having another conversation with my girlfriend about purchasing a home. I really like the area of Los Angeles where we reside. However, there is no way I could afford to purchase a home here. The question I often ask is how do people afford to purchase homes at the astronomical prices. What I’ve learned is that most people purchase homes with no money down, interest only (IO) mortgages.

I talked with one loan officer and he suggested that I take this route because according to him, I would ‘get left behind.’ I thought about it for a moment. Isn’t it better to have a home with a risky mortgage than not have a home at all? Before I could answer that question I wanted to know the ends and outs of IO mortgage option. What I found didn’t make me comfortable with that option.

Basically, it works like this. You purchase your and with an Adjustable Rate Mortgage (ARM) at 5% with no money down. For the first five or ten years, your interest rate is locked at that rate and the monthly payments cover only the interest so you are not paying down the principle. At some point, five or ten years depending on your mortgage, it is time to start paying the principle. However, instead of paying the principle down in 30 years, you now have to pay it down in 25 or 20 years. Making those mortgage payments much larger. To add to that, you are no longer locked in that low interest rate, so if interest rate rose over those years, you will pay the higher interest rate.

Here’s a chart based on $200,000 mortgage:

Monthly Payments First Five Years
30 Yr Fixed: $1231
IO Payment: $791

Monthly Payments After Five Years
30 Tr Fixed: $1231
IO Payment: $1413
Source:

These numbers are much more dramatic for those of us in California since purchasing a home for $200,000 is out of the question. When IO is the only option available to afford a $450,000 home, the monthly increase can place a stain on my household finances. Can you imagine going from an $1800 mortgage to a $3000 mortgage? That is the likely scenario for most Californians.

What most people are hoping for is that home value continues to increase at its current pace so they can sell before the larger payments arrive. However, any stall in the market or devaluation could leave a lot of people high and dry. If those with IO loans can’t afford the larger mortgage payments they could find themselves selling their home that has not increased in value they way they expected or worse, having to sell for less than the purchase price. Having not built any equity in the home and with the cost of selling a home, they could find themselves without a home and walking away with nothing or owing thousands of dollars.

Based on all of this information, I’m going to follow the advice of Susie Orman: If you can’t afford a home with a traditional 30 year fixed-rate mortgage, you don’t need to buy a home. There is a lot of information on Interest Only loans on the web. Just Google Interest Only and you’ll find out everything you need to know about it.