Next week merits a mark on the calendar with an announcement from Fannie Mae (Stock Quote: FNM) that it’s severely curtailing the availability of interest-only loans. Does that pave the way for the end of such loans? And what do the rules look like? Let’s take a look.

First off, let’s define an interest-only loan. Basically, it’s a mortgage where the borrower pays only interest for a fixed term. At the term’s end (usually five to 10 years) the loan converts to a fully amortized loan in which both interest and principal are paid. In other words, an interest-only loan means just that — the entire mortgage payment during that timeframe goes toward “interest only” — and not the loan principal.

The benefits to the borrower are lower payments early in the loan. That would help a young income earner whose salary will rise over time to “grow” into the higher mortgage payments down the road. Consider a $417,000 mortgage with a loan at 5% interest. With a traditional 30-year-fixed loan, the monthly payment would be $2,339. But with an interest-only payment, that monthly payment falls to just $1,738. (A tip: to calculate your potential monthly mortgage payments, use BankingMyWay’s Mortgage Loan Calculator.

The downside is that, by reducing early mortgage payments, interest-only loan borrowers will likely owe more money over the total course of the loan.

But the upside/downside issue may not matter any more. On June 19, Fannie Mae is going to put the interest-only loan in a major vise. On that date, all interest-only mortgage loans must fit the following criteria (from the Fannie Web site):

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  • The home must be a one-unit property.
  • The home must be a primary residence or vacation home.
  • The mortgage must be a purchase, or rate-and-term refinance. No “cash out” allowed.

While Fannie Mae will still offer interest-only loans, the company is severely curtailing the borrower’s financial criteria. Here, once again, from the Web site, are the details:

  • The maximum loan-to-value ratio cannot exceed 70%.
  • The borrower's credit score must be 720 or higher.
  • The borrower must have a minimum of 24 months of liquid asset reserves remaining after loan closing.
  • Balloon mortgages, which typically offer lower initial interest rates but leave a significant balance due at maturity, will no longer be eligible, except with special approval.

Sure, Fannie Mae does say that it still has interest-only loans on its menu. But its sister agency, Freddie Mac (Stock Quote: FRE), announced last September that it would end its interest-only loan program.

One has to wonder — is Fannie paving the way for a similar outcome? It sure seems that way.

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