Interest-only loans grow in popularity amid housing boom

By Rob Robertson
Memphis Business Journal
Updated: 8:00 p.m. ET June 19, 2005

As property values across the country continue to rise, more home buyers have begun taking advantage of interest-only mortgages, an increasingly popular loan that rewards buyers with initially lower monthly payments but also carries risks should housing prices suddenly drop.

Interest-only mortgages are attractive because they don't require payments toward the loan principal for a set period of time, typically 3 to 7 years, which lowers the cost of entry substantially because buyers are qualified on the lower interest-only payments. The mortgages are often included with adjustable rates.

The concept is not a new one. Interest-only loans have been around since the 1920s, but they were usually aimed at wealthy investors who were expected to use the principal portion of their payments for other investments.

Today, the product has become a useful vehicle for homebuyers of more modest means to be able to purchase nicer homes, even in markets where property values are extraordinarily high.

"They have really just taken off in the last year or two," says Bob Goethe, CEO of Memphis-based Regions Mortgage. "Three years ago we didn't even get calls about these loans."

The trend toward interest-only mortgages has been well under way in places like California, Florida, Arizona, Texas and states along the Atlantic Coast, where property values have increased the most in recent years.

In the Mid-South, where home values have been rising but at a much more moderate pace, the popularity of interest-only mortgages has been less pronounced. Curiosity about the loans, however, has been rising, say local lenders.

Ralph McNeely, manager of First Horizon's retail mortgage operation in Germantown, says interest-only loans are still something of a niche product here.

"Interest-only mortgages are much more popular in areas where property values are increasing rapidly," McNeely says. "Here, where housing appreciation is moderate, interest-only loans are more of a product for sophisticated borrowers, but a lot of people have at least been asking about them.

"It's a useful tool, but it's not for everyone."

McNeely says interest-only loans make up about 20% of First Horizon's mortgage business in Memphis, but that percentage is probably much higher in other areas, particularly the coasts.

Still, industry experts worry that the growing popularity of interest-only mortgages may further elevate already soaring housing prices, creating the specter of a crash that could cripple the economy.

In its most recent economic commentary, the Mortgage Bankers Association called the current behavior of the housing market "a gathering cloud on the economic horizon" and blamed the rapid rise in housing prices in part on the availability of products like interest-only mortgages that entice people to purchase more home than they can afford.

Goethe has observed the shift in the way people think about buying homes, as houses and their surrounding real estate are more often being treated as assets in investment portfolios rather than just places to live.

"People want to maximize the kind of house they can buy because they see real estate as a good investment," he says. "We're now seeing a substantial increase in customer interest in (interest-only) loans. In 2001-2004 we had historically low interest rates and people everywhere were refinancing. That wave has passed and now people are cashing in on real estate as the values keep going up."

A sharp downward turn in property values could saddle many borrowers who used interest-only, adjustable-rate mortgages with increasing monthly payments to finance homes worth steadily less. Such a worst-case scenario could result in the same kind of massive foreclosures that crippled the savings-and-loan industry in the late 1980s.

To prevent this, mortgage lenders must remain prudent in the face of rising competition created by the ample availability of mortgage credit, Goethe says.

"We're watching things very closely," he says. "When we make loans we look very carefully at the credit worthiness of a borrower to make sure that borrowers can afford the payments in future."

Indeed, home prices have risen considerably faster than workers' incomes, according to the MBA, which cited data from the Office of Federal Housing Enterprise Oversight. During the past five years, average home prices increased at an annual rate of 8.4% while weekly earnings in the non-farm business sector increased only 2.7%.

In the past year the gap has gotten wider, the MBA observes, as home prices have increased more than 11% compared to a 2.3% rise in average weekly earnings.

Most people think there is a higher probability of rates going up than going down, Goethe says.

"1-3 years ARMs are going to adjust up at some point and the question is can a borrower afford it when that happens," he says. "We'd be doing a disservice if we didn't take that into consideration."

Most experts agree that the likelihood of a catastrophic drop in property values is remote; a more likely scenario involves a gradual decline in the rate of growth as long-term interest rates increase.

In any event, McNeely says the Mid-South is in a better position to weather any sudden downturns in the real estate market because of its historically steady property values.

"We'd be better off here than in other regions," he says. "If property values decreased it would be a detriment and people must consider that possibility, but our area has always been stable. There haven't been many booms or busts here (relative to other regions), and I think it will stay that way."

South End generates $285M in new projects

Amos Maki

When Terry Lynch and his partners started buying property four years ago in the area of Downtown known as the South End, other developers had already passed on the area. But Lynch, president of The Southland Cos., saw promise where others saw nothing but peril.

With $285 million worth of development in the construction and planning phases, the South End neighborhood Lynch and his wife, Robyn, along with partners Karl and Gail Schledwitz, set out to develop is ready to blossom with almost 1,300 new residential units. Once a relatively forgotten part of the city's Downtown populated mostly by industry, the South End is now being transformed into a "pedestrian friendly neighborhood" with multiple products at multiple price points.

One new project, called the Art House Apartments at South End, will add 302 rental units to the Downtown market. The $30 million project, located at Florida and East Carolina, will have a series of courtyards inside the development that will feature works from local artists and have a five-level parking facility. The complex will be equipped with wireless Internet access, a swimming pool and live-work spaces for residents.

"This will be a space for the younger people who respect and like the art community and it will ripple through the whole neighborhood," Lynch says.

An Atlanta-based company is under contract to build the complex. The units are expected to rent for $700-$800 a month.

The conversion of the Hoover Building on Georgia, home to Dabney Hoover Supply Co., Inc., will add 42 new condos to Downtown in 2007.

Over the next few months, construction on City Commons Too at South End, a development featuring 11 townhouses starting at around $350,000, should start. City Commons Too is right next to City Commons, the development by Chamberlain, McCreery and Rice that will add 44 condos to Downtown.

Other area projects long in the works are starting to come to fruition and many have pedestrian friendly elements.

Construction on Carolina Lofts at South End, a $12 million Faxon & Gillis development featuring 12 townhomes and 60 condos, has begun.

The Rooftops at South End, a $5.5 million Southland Capital Partners project featuring 12 townhomes, is nearing completion. Six of the units feature additional living spaces called "granny flats" that come equipped with full kitchens and baths. The units with the granny flats will sell for $471,000 and city codes allow the extra space to be rented out. The remaining six units without the flats will sell for $371,000. All 12 units have rooftop decks that offer stunning views of the Memphis skyline, from FedExForum to the Hernando DeSoto bridge.

"We've found that the younger people like the energy of the skyline," Lynch says.

At Georgia and Riverside Drive, Jason Crews is adding two floors to the old Memphis Imports Building. The $16 million project will have 66 condos, covered parking, a workout area and a common gathering place. Tom Davis at Henry Turley Realtors is selling the units, which range from $166,500-$430,000.

Davis is also handling the sales for City House Cosmopolitan Lofts, which is still under construction and includes almost 5,000 square feet of retail space on the ground floor. To date, 28 of the 36 condos in the $12 million project have been pre-sold. Architectural CustomWorks is the developer.

"We wanted to open the ground floor of the building out to the street and thought retail was the best way to do that," says Berry Jones, principal of Architectural CustomWorks. "A relationship to the street and maintaining a good connection to the street keeps the project exciting."

Most of the projects on Southland's property have been in the works for years, but it took time for company officials to find developers committed to their ideas of new urbanism and to clear government hurdles.

Southland Development Partners, a division of The Southland Cos., spent about $4 million buying 15 acres of property and improving some infrastructure in the area. The company asked Looney Ricks Kiss to develop a conceptual master plan for a 30-acre area in the South End. Southland Development Partners has implemented architectural and design guidelines for developers to follow.

Jeff Sanford, president of the Center City Commission, says that while many thought the area was ripe for residential development, few had the courage to pour money into land assemblage.

"I have to give Terry and Karl a lot of credit," Sanford says. "Not only did they step up and purchase property, but they very wisely invested in a sophisticated plan to create a new, attractive, high-density urban neighborhood."

Southland Development serves as the master developers for the site and all the projects are required to follow its "new urbanism" guidelines: Maximum density and pedestrian friendly spaces.

"We're not just selling land down there," Lynch says. "We're selling a concept they're buying into."

While the new urbanism phrase may be a recent addition to developers' lexicons, the principles behind it aren't that new at all.

"New urbanism is a catch-phrase everybody is latching onto, but it really is good, common sense planning," says Tony Bologna, president of Bologna Consultants, an architectural and consulting firm. "The whole idea is a smart way to live.

"It's progress in the best sense of the word," says Bologna, who practices the new urbanism ideals he preaches. His office on Mud Island is in walking distance from his home, a grocery store, barber shop and dry cleaners.

Lynch and his partners don't want suburban-style developments popping up in their end of Downtown, and they seek out developers with expertise in urban development.

"In Downtown, most of your local developers and builders who have come Downtown have not been exposed to new urbanism principles," Lynch says. "A lot of times they are still building a suburban style interior product. On most of the major projects within our master plan, I've gone out of town to get people with an urban strategy."

That's why Southland Development brought in Atlanta-based Beazer Homes to build State Place at South End, a $49 million townhouse and condo development. Construction on the project, which will eventually have 108 townhomes and 96 condo units in a 5-acre gated community, should begin this week.

The guidelines set up by Southland Development will contribute to high residential density. There will be about 40 units per acre in the area, compared to about 14 units per acre in Harbor Town.

To bring the South End neighborhood and its residents closer to the river, Lynch will spend $200,000 to connect Channel 3 Drive to Kansas Street. Currently, residents of the area who want to visit Martyrs Park must brave traffic on Riverside Drive to get there.