There is another type of loan product that was very popular when the real estate market was on the rise, but much less so following the collapse. This product is known as the “interest only” loan. The basic concept of the interest only loan was that payments made based on the loan amount were to go directly towards the interest which represented a percentage of what would be a “normal” payment. There was also options to secure a loan at a lower overall interest rate as well.
The downside to an interest only loan is that the loan amount never decreases. The principal of the loan never decreases. So, any equity in the home would be based strictly on the home value increasing as the market increased. Typically the interest only part of the loan had a time limit set, usually around 2 or sometimes 3 years at which point, the rate returned to “normal” or usually slightly higher than the normal going rate and then the monthly mortgage payment would apply not only to the interest, but at that point would also go into paying down the principal loan amount.
This was a great tool for those interested in investing as a speculator and this happened a lot in Salt Lake City area as well as all over Utah. The purchase of the home was done with the intention of selling it 90 days later or so and the monthly payments between the time the initial home was finished compared to the amount of money made on the future value or sale of the home was negligible. In fact, there were options as well to rent out homes doing this interest only where the rent amount could even cover the monthly payment on the interest.
The risk with the interest only loans was that if the time elapsed when the loan because due or the payments changed from being interest only to a regular payment, the market may have changed in that time and there is some difficulty refinancing, the home may be lost and the bank would take ownership.
To understand the concept of risk vs. reward is to understand why the banks have some great deals for a short period of time which convert to bad deals if held on too long. The interest only loans during a time of prosperity and abundance are great because they benefit the borrower who has a lower monthly payment and it also benefits the bank who maintains the same loan amount and simply collects interest on their money. If there were no other changes to an interest only loan and instead of either being modified into a fixed rate or variable rate mortgage, the loan was held and interest was still paid, it would be the same as if you were a tenant renting your home but the bank was really the owner as the principal amount on the home wouldn’t have changed.
These interest only loans still exist and are used, but much less today than a few years ago. The majority of Salt Lake City mortgages today are not interest only and are more traditional, both using the ARM as well as the fixed rate mortgage.