Interest-only mortgages are hot, but they pose risks for clients.

    With production of interest-only mortgages on tap to be even greater in 2005 than in 2004, financial advisors have a number of issues to consider.
    Already, 63% of mortgage originations in the second half of 2004 were adjustable-rate or interest-only mortgages, according to the Mortgage Bankers Association in Washington, D.C. Published reports have indicated that in some areas, interest-only loans represent the majority of the mortgages taken out to buy a home in the first two months of this year.
    This trend comes despite a much smaller increase in interest rates than when this has happened in past cycles. "The trend is to get the borrower as much money as possible, to put down as little as possible and pay back as little as possible for as long as you can," warns George Yacik, vice president for SMR Research Corp. in Hackettstown, N.J.
    The problem: At some point, if interest rates rise, he says, "the payment is going to rise. Some may find themselves in a situation where they can't make payments. Or, it could be a negative amortization situation, where the borrower could owe more than the house is worth. In the past, some people have walked when they hit that situation."
    With a controversial interest-only mortgage, the borrower makes interest-only mortgage payments each month for a specified period. The monthly payments generally are lower than those of a traditional 30-year fixed-rate loan. In addition, monthly interest-only payments typically are income tax deductible.
    The downside: At the end of the interest-only payment period, the full principal still must be repaid.
    The pricing of these mortgages often changes dramatically after the interest-only period. The change could pose serious risks to a borrower who has not yet sold the home or refinanced. Among those risks: enormous monthly payments. Even with a monthly payment cap, the mortgage balance could increase if rates rise. No rate increase? A borrower still could face hefty monthly payments. Some programs amortize the principal and interest over a much shorter period than a traditional 30-year mortgage term.
    Despite potential payment problems, interest-only mortgages have their share of supporters. In states where home prices are soaring, interest-only mortgages may be the only way people can afford to buy a home.
    Chris Zehnder, a St. Cloud, Fla., fee-only advisor and former mortgage banker, says he may use an interest-only program if a client has enormous debt and needs to free up cash flow. However, he stays away from programs that have negative amortization, in which rising rates could cause a client's mortgage balance to rise.
    Zehnder, owner of Zehnder Wealth Management, says he is careful to tell clients they need to start making payments at some point. Interest-only mortgages, he says, also are attractive for persons who plan to stay in their home for less than four years.
    With a 30% increase in property values in his market over the last year, affordability is a major issue. Zehnder's lender waives his clients' mortgage processing fees and prep fees. On at least one program, title insurance and appraisal fees are charged to Zehnder's clients in the form of discount points, so they may be tax deductible.
    Mortgage broker Gibran Nicholas, president of Nicholas & Co. Mortgage Planners in Ann Arbor, Mich., works with a large number of financial advisors. He acknowledges that the interest-only LIBOR (London Interbank Offered Rate) adjustable-rate mortgage he aggressively sold last year through financial advisors is not necessarily best for borrowers today. But he has not abandoned his staunch support of interest-only mortgages.
    "Most homeowners would be better off financially by not paying the principal on their mortgage, and utilizing their monthly cash flow to better prepare for retirement and their financial needs later in life," he declares.
    At this writing, Nicholas was projecting a two percentage point rate increase, to 5.05% by the end of June, on the original interest-only adjustable rate mortgage he sold through advisors last summer. In this scenario, a borrower's payment on a $200,000 loan would have risen more than $300 to $842 from June 2004 to the end of June 2005.
    He is refinancing those borrowers into another mortgage with interest-only payments, in which the interest rate is fixed for a period of either five, seven or ten years. Take a seven-year fixed-rate, interest-only program: The rate at this writing would be 5.5% for seven years with a lifetime rate cap of 10.50%, he says. In the eighth year, the interest rate becomes subject to change annually for 23 more years, based on the one-year Treasury index ARM plus a margin of 2.75%.
    A client's monthly payment is locked in for seven years at $917-a bit more than the $842 payment the borrower was expected to be paying on the original adjustable-rate, interest-only mortgage. But it's still lower than the $1,167 monthly payment on the going rate of 5.75% for a no-closing-cost, 30-year fixed-rate mortgage.
    If the rate on the seven-year interest-only program hit the 10.50% lifetime rate cap, the payment in year eight would be $1,924 amortized over 23 years, he figures. Of course, the client would move to refinance before that happened. Nicholas, for financial advisor clients' refinancings, is waiving closing costs.
    Ron Chicaferro, executive vice president of Thornburg Mortgage Inc., Santa Fe, N.M., says his company, too, waives a $490 lender fee to borrowers-strictly as part of his financial advisor program.
    The increased use of interest-only mortgages and other risky mortgage programs could impact a client's long-term financial plan. Jovita R. Honor, a fee-only advisor for Prialta Advisors in San Jose, Calif., notes that risky mortgage programs ultimately could dampen the real estate market if rates rise.
    Traditional financial planning calculators and software programs may not thoroughly consider this factor. Plus, she believes, an advisor may need to adjust a client's real estate or mortgage-related investments in preparation for such a downturn.
    Honor, a former mortgage underwriter, says that California borrowers can't afford homes today without adjustable-rate or interest-only mortgages. Monthly payments are too high. Billboards in her area blare the availability of interest-only mortgages to all. In fact, she's worried about her sister, a schoolteacher, who shunned Honor's advice and took an interest-only mortgage so she could afford a home.
    In the face of these risky programs, Honor says she is more conservative with client real estate calculations. Say a client anticipates selling a home in five years to retire: To project client assets, "we used to assume a 3% annual growth in real estate," she said. "In the last two years, we've either been assuming zero percent growth or sometimes, even a negative 2% growth per year." 
    Investments she fears could be impacted by problems with risky mortgages are REITs, mortgage-backed securities and adjustable-rate bond funds. Risky mortgage programs, including those with interest-only payments, also have attracted regulators' attention. A financial advisor who accepts fees could get nailed on state or federal laws by a disgruntled borrower. The Real Estate Settlement Procedures Act (RESPA) prohibits kickbacks and referral fees.