Downward angle icon Downward angle icon. Interest-only mortgages were much more tightly regulated after the financial crisis, but higher-income borrowers are now turning to them as home prices remain high. Lance McMillan/Getty Images Some Americans who are higher-income but not yet wealthy are opting for nontraditional mortgages. Interest-only mortgages offer lower monthly payments, at least at first, but can be risky. These mortgages are ideal for luxury property buyers who have money to invest elsewhere.
As home prices and mortgage rates soar, prospective homebuyers, even those with the means, are looking for ways to ease the cost burden.
Some high-income but not-yet-affluent Americans, known as “henries,” are choosing an unusual interest-only mortgage that makes buying a home easier, at least in the short term. The loan allows borrowers to pay only interest and no principal for a set period of time. The loan is aimed at wealthy buyers who have enough savings to afford a large down payment and buy luxury properties.
This type of loan has several attractive advantages: the initial monthly payments are low, allowing borrowers to put the money they would otherwise need to pay off their mortgage into higher-yielding investments, and borrowers who expect their income to rise in the future can purchase more expensive homes that they otherwise could not afford.
They are also riskier than regular mortgages. Borrowers cannot get more equity in the home than they put down. Mortgage payments may increase in the future, and if home values fall, they may lose equity or be unable to refinance. Some interest-only loans require borrowers to repay the entire principal at the end of the interest-only period.
When Sam, whose last name Business Insider knows, and his wife were looking to buy a house in Brooklyn in spring 2022, the home they liked was well above their $2 million to $2.5 million budget.
Then one day, an unexpected opportunity presented itself: Their neighbor across the street from their rental apartment in Carroll Gardens was selling a three-bedroom brownstone. It was exactly what they were looking for, but it was priced at $3.1 million. But their neighbor was willing to sell it to them before putting it on the market. After agent fees, the house was worth about $2.8 million.
Sam, a self-employed marketing consultant, initially worried buying the home would be too risky and expensive: The future of New York City real estate was still uncertain, with many who fled the city at the start of the pandemic slow to return.
But when First Republic Bank offered him and his wife a 40-year, interest-only loan, they accepted: They'd put down a 20 percent down payment and lock in a low mortgage rate of 2.6 percent to 2.7 percent for the first 10 years of the loan, at which point the interest rate would double.
Their monthly interest-only mortgage payment is just under $5,000, only a few hundred dollars more than their previous rent.
Eighteen months later, Sam and his wife are still happy with their decision. They can afford the payments now, they're saving for future interest rate hikes, and Brooklyn real estate is booming. They plan to stay in the house for 15 or 20 years, by which time their kids will have graduated from high school and they might want to downsize or move out of Brooklyn.
“These days, people seem pretty sure that in 10 to 20 years, it's going to be worth more,” he said. “It might go up a lot, it might go up a little, but it's not going to go down.”
Deals for “sophisticated investors”
Sam and his wife are a good target demographic for an interest-only loan. However, this type of mortgage can be very risky if the borrower does not have enough funds to meet the higher payments in the future or if the property value declines. In that case, the borrower must prepare for the possibility of interest rates rising after the initial phase of the loan is over.
Chen Chao, head of economic research at Redfin, said these loans are a “niche product” that should be used by borrowers who are “sophisticated investors” to buy luxury properties. Interest-only mortgages don't increase the equity of a home, so borrowers should invest their money in other ways that are likely to produce higher returns, Chao said.
The proliferation of interest-only mortgages could even hurt buyers who can least afford them. Because they allow wealthier borrowers to buy more expensive homes, they could contribute to inflating prices in an already costly market. Claes Backmann, a researcher at Germany's Leibniz Institute for Financial Studies (SAFE), who has studied the introduction of interest-only mortgages in Denmark, says the types of loans don't significantly increase homebuying ability or enable more young people to own a home.
“I think it certainly helps buyers who can afford these homes, but when they're competing with other buyers who can also get an interest-only mortgage, there may not be much benefit in terms of affordability,” Bachman said.
Renzo Salazar, who was hired by the bank to keep a foreclosed home from falling into total disrepair, tends to the yard around the house on November 10, 2011 in Miami, Florida. Joe Raedle/Getty Images
History of predatory lending
Interest-only mortgages were much more common, especially for less affluent borrowers, in the years leading up to the 2008 financial crisis. At the time, many homebuyers were offered riskier loans that they couldn't afford, ultimately leading to the subprime mortgage crisis.
After the financial crisis, the federal government passed restrictions on riskier mortgages, making interest-only loans much less common than they once were. But with home prices soaring and interest rates remaining high, buyers are again opting for riskier loans, including interest-only loans.
Business Insider knows Hillary's last name, but asked to remain partially anonymous to protect her husband's business. Hillary and her husband were victims of these unscrupulous lending practices. In 2007, the couple took out an interest-only mortgage to buy a $585,000 home in San Diego. The house was close to Hillary's mother's house, and the couple wanted it to be their permanent home, so they took the plunge. Their real estate agent warned them against taking out such a high-priced loan with such a high interest rate, but the bank recommended they take out two loans with no down payment, one at 8% and the other at 9%.
When the financial crisis hit, Hilary's husband, a commission-based financial advisor, saw his income plummet. Hilary, a self-employed photographer, was also hit hard. Then the couple had a child. They were soon forced to take out a loan to pay the $4,000 monthly mortgage payment. They asked the bank for a loan modification, but were refused. The couple declared bankruptcy and eventually sold their house in 2012 for just $365,000.
Looking back, Hilary believes she and her ex-husband were overly optimistic about their future income when they bought their house, but that the bank was being reckless.
“Obviously, they shouldn't have given us the loan,” Hilary said. “But when you're young and it's what you call the perfect home, how do you do that?”
She worries some buyers are falling into a similar trap, believing they can refinance their loan later and get better terms.
Looking at the real estate industry as a whole, interest-only mortgages may be contributing to the new crisis. Interest-only mortgages have become increasingly popular among commercial property buyers in recent times. According to a Wall Street Journal report based on data from Trepp, interest-only mortgages accounted for 88% of new commercial mortgage-backed loan issuances in 2021, up from 51% in 2013.
Things aren't looking good for borrowers. Commercial mortgage defaults are on the rise. Interest rates are too high for many office building owners to secure new loans they can afford. In May 2023, Fitch Ratings estimated that 35% of the pool of securitized commercial mortgages maturing between April and December of this year will not be eligible for refinancing.
Consumer advocates worry that homebuyers are increasingly choosing riskier, non-traditional mortgages. Some borrowers are attracted to interest-only loans because of their lower monthly costs, but they are not prepared for the worst-case scenario and may end up paying more to own a home.
“The question is whether people understand that this is a product that will cost more in the long run, or if they're just attracted to the lower monthly payment,” Bachman said.