On the Wall Street hit list - Interest only loans

Roger Schlesinger
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Posted: Aug 31, 2006 12:00 AM

Why is Wall Street so interested in the real estate market? They seem to have an opinion on every aspect, whether they understand it or not, letting nothing stand in their way. I hear interviewers talk about how real estate is falling off a cliff, the bubble is bursting, sales are down further than anticipated, inventory is up higher now than in years and many houses are vacant. These are just some of the comments that come out on a daily basis. I am neither interested in challenging these thoughts or concurring with them, because they are not integral to my thesis. But I bring them up to show the Wall Street bias to real estate. Apparently, real estate is perceived as serious competition to investment in the stock and bond markets.

I will mention that although the comments keep coming, real estate nationwide is still showing gains, not losses. Also, the biggest markets like San Diego, California are showing some downturns, but only around 1%. If value remains in a market where there is little demand and excessive supply, what is going to happen when demand returns?

I really wish to concentrate on interest only loans, which leads a list of little respected vehicles available to real estate owners. I wish to compare and contrast many aspects of the interest only loan to other phenomena we have in our society.

As an example, according to Wall Street, the interest only loan isn't smart or safe, but leasing a vehicle is fine.

When you realize you are only paying for the utility of the vehicle and not the vehicle itself, you have to wonder how this compares to the interest only loan. Vehicles predominately lose value, and houses generally gain value. Without getting into the nuances of the auto lease vs. interest only mortgage loans, I believe there is greater reward in interest only loans than there is in auto leasing, yet auto leasing is not on the "financially dangerous" list and interest only loans are.

The Wall Street crowd will sell you a "growth stock", one without a dividend, and tell you the reward is in the growth of the company and the increase in the share price as a result of the growth. Why isn't an interest only loan a "growth loan" with the payoff coming with the increase in value of the house and the low, tax-deductible expenditure on the loan? They fail to mention it!

Now let's look at the interest only loan and compare it to a fully amortize loan, preferably the 30-year fixed. The 30-year loan will amortize about 12% in the first 10 years. On a $300,000 loan at 6%, you will have a balance of approximately $260,000 after the first decade of the loan. If you were to take an interest only loan at the same balance and rate, you would save $36,000 in actual payments, or almost the same as what was amortized. If you invest your savings stream you might be way ahead of the game.

There are two ways to make money in real estate: amortization -- paying down the loan until it is gone (30 years) or having the house go up in value, which is by far the major way people make money in real estate. If you were really interested in amortizing your loan, you would take a 10, 15 or 20-year fixed, not a 30-year.

Now, let us take a look of the benefits of an interest only loan, other than lower payments. If you own rentals, then interest only gives you the lowest positive payment you can get and it will enable you to enhance your rental income.

If you are self employed, a commission salesperson or receive a nice bonus each year, then you can enjoy low monthly payments and when you receive a good amount of money, you can pay it in against the principal. Besides paying down the loan, it will reduce the monthly payment subsequent to the pay down, as interest only loans are based on the actual balance of the loan, not the beginning balance.

The message is simple: Don't disregard a loan because a group of people tells you it is dangerous for you to consider. Investigate for yourself and see if this loan is the best way for you to maximize your particular situation. Blanket statements are at best a warning for you to check out every aspect of a particular strategy, and at worse, a total disservice to all.

Roger Schlesinger's Mortgage Minute is heard on hundreds of radio stations and daily on the Hugh Hewitt radio show and Michael Medved shows. Roger interacts with his hosts and explores the complicated financial markets in order to enlighten his listeners and direct them along their own unique road to financial freedom. Roger is the President and founder of Manhattan West Mortgage.