Interest Only Loan...Is
it Right for You?
Interest-only mortgages are pushed aggressively nowadays by lenders and
brokers, but they're not for everyone.
An
interest-only mortgage might be a good fit for:
- someone whose income is
mostly in the form of infrequent commissions or bonuses;
- someone who expects to
earn a lot more in a few years;
- someone who truly will
invest the savings on the difference between an interest-only mortgage
and an amortizing mortgage, and who is confident that the investments
will make money.
Financial advisers don't recommend interest-only mortgages to regular
wage earners who take out moderate-size home loans and don't
have a strategy for investing the savings.
With an interest-only
mortgage loan, you pay only the interest on the mortgage in
monthly payments for a fixed term. After the end of that term, usually
five to seven years, you either refinance,
pay
the balance in a lump sum, or start paying off the principal, in which
case the payments jump skyward.
Who
Should get an Interest Only Mortgage?
If there were such an animal
as a typical interest-only borrower, it would be an executive who earns
a moderate salary and whose main income is from bonuses once or twice a
year. An interest-only mortgage would provide the lowest possible
monthly payment for lean months, yet allow the executive to pay down big
chunks of principal when bonus time rolls around.
Business owners with
unpredictable incomes might benefit from interest-only mortgages, too,
because they need to maximize their cash flows as much as possible, and
this is a great way of doing it. And, of course, you have the option of
paying down principal whenever you want.
Beware:
Marketed to the General Public
Historically, interest-only
mortgages were for affluent borrowers but you've seen the product come
down-market a little bit in the last couple of years.
When you go too far
down-market, interest-only loans don't save enough money to be
worthwhile. Let's say you borrowed $200,000 at 7 percent. For the first
three years, the savings from an interest-only loan would amount to less
than $200 each month. Double the loan amount to $400,000 at 7 percent,
and an interest-only loan saves more than $325 in the first month.
Some lenders push these
loans because they provide borrowers with a lot of flexibility. They're
available in typical-size loans - even for under $200,000. The power of
an interest-only loan kicks in, some loan officers say, because "you can
buy much more house."
Buying
More Than You Can Afford!?
The inference is that an
interest-only mortgage allows one to buy more house than one can afford.
In fact, many unknowledgeable loan officers push these loans to
borrowers that don't fully understand what it all means. When a
loan officer cannot fully understand the product, there is no possible
way the borrower will be well-informed, a recipe for disaster.
Many financial planners generally frown
upon interest-only mortgages. They say these loans might be legitimate
for fast-trackers who need to present an upscale image for career
success but with the sheer number of these loans being closed, it's
obvious the average wage-earner is jumping at the chance to own a more
expensive home than they realistically can afford.
The
Traps are Set...
Among the traps are the
risks that the house will lose value and that the borrower will lose a
job.
Mortgage lenders say
interest-only mortgages benefit borrowers who invest the money they
would have paid as equity. They come out ahead if their investment
returns exceed the rate of home appreciation.
For someone who
says, 'It would be better to put my assets into a stock portfolio or
college education for my kids,' the interest-only gives you that
flexibility. This idea fits in with the philosophy that middle-class
people should have the tools to manage their debts as carefully as they
manage their assets. But many people who
are getting these loans simply do not have the financial discipline to
invest the money they would've normally paid in.
Lots of people tell
themselves that they'll invest the difference between interest-only and
amortizing mortgages, but not all of them follow through.
The money is there, tempting them to spend it on boats, vacations,
pampered lifestyles.
Tax
Benefits...
Financial Planners contend
that on the rare occasion they would advise these types of loans, it
would best be suited for the "up and comer" as noted above OR for those
in a higher tax bracket that simply need the interest deduction for tax
purposes.
For example, if a retired
homeowner has a $45,000 mortgage but could easily pay it off with
a check, the 4.75 % interest-only loan is tax-deductible - and if the
homeowner is in the 38.6 percent bracket, this would be of benefit to
the homeowner. With the tax deductibility, he'd be borrowing at an
effective rate of less than 3 percent. It's a slam dunk to earn more
than that with a well-diversified investment portfolio so why pay off
the loan?
Care is Needed...
There are times when an interest only loan
makes sense but if you are using such a loan to enable yourself to buy a
home that is realistically beyond your means, you are headed down a
rough road.
A competent mortgage professional can be a
tremendous asset when trying to decipher the type of loan that is best
for you. The Residential Mortgage
Advocates™ listed on this site have signed a commitment to looking
out for YOUR best interests. Work with a professional that cares
about you in the present and future!
All members on this site have signed a
Residential Mortgage Advocate™ (RMA) commitment to be totally upfront about
their fees, rates and items they will need from you.
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