If lots of your prospective neighbors are taking out loans with low initial payments but much higher costs down the road, it could mean that they're stretching to buy houses they otherwise couldn't afford (see BW Online, 06/16/15, "The Mortgage Trap"). That's a sign of an overpriced market.
The red lights are flashing in San Diego, Atlanta, San Francisco, Denver, and Oakland. Last year, they had the highest share of single-family-home mortgage loans that require just interest payments -- no principal -- in the early years. San Diego led overall with 47.6% of home buyers taking out interest only mortgages, up from 1.9% as recently as 2001.
SIGNS OF OVERHEATING. Providence, Indianapolis, Houston, Pittsburgh, and Milwaukee are at the other extreme, with fewer than 8% of buyers going for interest-only mortgages last year. The data, which appeared first on BusinessWeek Online, were supplied by LoanPerformance, a San Francisco real estate information service. On a national basis, the LoanPerformance numbers closely track those of Fannie Mae and Freddie Mac, even though those companies buy standard mortgages while LoanPerformance's numbers cover only big-ticket "jumbo" loans and subprime mortgages.
Why are interest-only mortgages a warning sign of a possible bubble? They tend to be most popular in overheated markets, where buyers are looking for every trick to make their monthly payments affordable. Initial payments on an interest-only mortgage are low because borrowers aren't required to pay any principal. But after a period of time -- from 2 to 10 years -- principal payments begin, and the monthly payment jumps by as much as 50%.
Be especially cautious of markets in which option adjustable-rate mortgages are hot. These loans offer borrowers extremely low teaser rates -- typically, just 1% for the first month -- and allow the option of making a minimum payment that may not even cover all of the interest owed for the month. The unpaid interest gets added to the principal, so the total owed can swell like a credit-card bill.
EYE ON PRICES. Borrowers may be enticed by the introductory rate but unprepared for later payments on the swollen principal. Keith M. Schemm, a mortgage broker in Santa Clara, Calif., says option arms are "pretty dangerous loans to do" for many families. "The problem is there's such a frenzy in the marketplace to buy a home."
In assessing a market, also look at whether house prices are high relative to local incomes and relative to rental rates on equivalent properties, and at the health of the local economy. If major employers have recently closed, home prices are likely to head down. But if you're worried about buying at the top of the market, knowing what kind of mortgages your neighbors are choosing should help you make a more informed decision. Coy is Economics editor of BusinessWeek in New York