These loans were among the most popular. With a typical payment, you pay principle, interest, taxes, and insurance. The bank takes your full monthly payment and uses the money to pay for the various items. The bank keeps the interest and principle portion of the payment and saves the balance to pay the property taxes and the homeowners insurance when they come due.
These loans were extremely popular with investors because they figured property values would continue to climb and they could collect rent for a few years and then sell the properties for a quick profit. Many investors made the smallest payment possible to get as much cash flow as they could. This is called “pick a payment. "
Unfortunately, it didn't work out very well. Property values fell, the mortgage payments reset to a higher amount, rent didn't cover the new payment, investors home mortgage payments also reset, gas prices went up, people moved into cheaper rentals, properties became vacant, and investors started losing their shirts across the country.
The biggest problem with interest-only loans is that people borrow based on the payment. If $725 is the most you can afford, you don't buy a house with an interest-only payment of $725. You buy a house with a PITI payment of $725. I feel that the lending industry used extremely poor judgment giving loans that people could barely afford with the low interest payment knowing the payment was going to reset soon. Since most of us think in the “here and now", people weren't prepared when their payments started rising.
Like investors, many homeowners figured they would refinance their houses when the new payment came due because property values were rising. Unfortunately, property values dropped and people found themselves owing what their house was worth and unable to refinance. The fact that no one could refinance caused a recession. Most of the initial interest-only loans were given with a two, three, five or seven year fixed rates. This is why foreclosures are going to continue to rise - the three, five and seven year loans haven't reset yet.
Dwan Bent-Twyford is the Co-Founder and Faculty Head of Real Estate Investing - Short Sale - Real Estate Foreclosures, a company that specializes in training new and seasoned investors in a wide range of real-estate investing techniques through live workshops and seminars. Dwan is President of Financial Freedom Through Foreclosures. Her company specializes in educating new as well as seasoned investors through a series of home study courses.