Suppose a bank decides to offer a large number of interest only mortgages. 1. Do you...

Suppose a bank decides to offer a large number of interest only mortgages.

1. Do you think that they would get a lot of business?

2. Would they be setting people up for negative financial outcomes (and should they have any responsibility for them)?

3. Suppose additionally that these loans were adjustable rate. How would do you think the uncertainty of a mortgage payment (like that of an ARM) would change a person's saving and spending habits?

Solutions

Expert Solution

An interest only mortage is one in which the mortgagor is required to pay the interest on the loan for a period. The principal is repaid later either in lumpsum or in parts.

This means only interest is collected initially and no principal repayment collected.

1. Would they get a lot of business:

There are certain reasons why they would get a lot of business, the following are the advantages offered to the borrower:

Initially nterest-only mortgages mean lower payments for a duration

It allows the mortgager to build up equity to pay the lumpsum principal payments later.

It is akin to a quasi moratoriam perod.

Hence they might get more businesses since the repayment terms are more attractive.

2. Negative outcomes

The probability of negative outcome does seem more likely in such a loan structuring

Need to build up equity before repayment, if that is not done, the principal payments could be huge.

There will be interest build up and principal to be repaid later, and if they are out of funds, or no built up equity they could lose out.

Risk of bancruptcy is higher

3. Usually, interest-only loans are structured as a particular type of adjustable-rate mortgages

Due to the uncertainty of the interest payments of the ARM it gives a false sense of confidence.

While an ARM fluctuates with the change in interest rates, it usually does not go below a certain percentage.

Due to these reasons , there is a big chance that the borrowers heavily underestimate the payments.

Again this leads them to overspend, and under-provide for the loan payments in the later duration , and the risk of defaults of interest only ARM mortgages are much higher.

jeff jeffy answered 1 year ago

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