Non-Traditional Financing Devices So Yesterday

Rob left a comment on my previous post with some insightful remarks. Referring to this article on washingtonpost.com, Rob warns about the problems that may soon result from the exotic financing devices that have become all the rage among borrowers and lenders during the real estate boom.

The article points out that during the first half of 2005 in DC, 54.3% of all homes purchases used interest-only loans. The plus side of an interest-only loan is that the monthly payments are lower because you are only paying interest, no principal. But as Rob points out, the problem with these types of loans is that the borrower is not building any equity in the property through paying down of the principal. During a boom period when housing prices are increasing, this is not such a bad proposition because the borrower is building equity in the property as a result of its increasing value. But if prices are flat for 4 or 5 years, the borrower is not building equity in the property at all, neither through monthly payments of principal, nor through increasing value. You could say you are basically renting from your lender except with all the headaches of a homeowner.

A second article in the Post describes the increase in no money down loans, another non-traditional financing device. That article cites a study by the National Association of Realtors finding that 40% of recent first time home buyers financed their purchase using no money down loans. There has been a greater than 50% increase in borrowers going this route over the last two years. As opposed to a borrower looking for the low monthly payments of an interest-only loan, nothing down loans are attractive to borrowers with little or no savings. The problem is that many (of course, not all) borrowers who have not been able to build up some kind of nest egg, will also not be able to make their payments consistently for 30 years. The probability of this occurring is increased by the fact that the monthly payments will be significantly higher if you finance 100% of the purchase price as opposed to putting down 20%. But lately, the pull of the real estate market has been just too great and even the savings-challenged have wanted in. Lenders have obliged.

Does this make sense from a lender's perspective? During a boom, yes, because the lender is in a win-win situation. If the borrower can make his payments, great, more money financed means more interest collected. If the borrower isn't able to make the payments down the road, that's OK too because the borrower either sells the presumably well-appreciated house and easily pays off the loan or goes into default and the lender forecloses. But what happens, as Rob pointed out, when inventory increases to the point that sellers have to slash prices and houses sit on the market for extended periods of time. The nothing-down party kind of comes to an end for borrowers and it'll probably be no picnic for lenders either.

Both of these types of loans, relatively unheard of for home buyers 10 years ago, appear extremely attractive to the borrower at negotiation time when viewed in light of their current personal situation and that of the market. But a downturn in the future, either in the market or the borrower's personal situation, can make a once attractive loan turn in to an unmanageable nightmare. The result could be a flood of foreclosures driving inventory even higher. On the bright side, savvy investors, start scouring the classified for sales on your local court house steps.

That's not to say there is no time or place for an interest-only or no money down loan. So-called "real estate investment guru" Robert G. Allen, author of Nothing Down for 2000: Dynamic New Wealth Strategies in Real Estate, is a staunch advocate of finding ways to finance real estate investments using anyone's money but your own. It is important, however, to know what you're getting in to. Because of the long-term uncertainty associated with these types of loans, they are better suited for short term investments, not for a house you plan to occupy for 15 or 20 years.

The key, as always, is knowledge and an eye towards the future. You must examine both the pros and cons of what you propose to undertake, not only under present circumstances, but under all possible future situations, good, bad, and ugly.

While Rob makes several great points about the state of the market, I stand behind my original statement that if, say, you're looking to buy your first home or have a portion of real estate investment among your well-balanced portfolio, there's no need to hit the panic button for fear of a bubble burst.

For more reading, see Who Should Get an Interest-Only Loan? by Holden Lewis and Interest-Only Mortgages Stage a Comeback by Jay MacDonald, both at bankrate.com. Keep in mind, however, that these articles are from October 2004 closer to the beginning of the boom and the advice given in them does not necessarily apply under the market conditions at present.
Remember, I talk like I'm an expert, but I'm not one.