Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Refinancing with an interest-only mortgage

Dear Dr. Don,
I'm considering refinancing with a 10/1 interest-only mortgage based on a 30-year payoff. I was advised that my monthly payment (interest only) would be based on my principal balance.

That leads me to believe that if I made principal payments on the loan then my interest payments would go down. Yet I've read that the monthly interest would stay constant through the initial term.
Walter Warrant

Dear Walter,
You need to ask yourself why you're considering an interest-only mortgage for a refinancing. Your monthly payments will be lower because you aren't making principal payments, but you're also not building any equity in your home other than any price appreciation you realize in your home.

You're correct in thinking that when you make additional principal payments the interest expense on your loan drops and the monthly payment should drop as well. The 10/1 interest programs I've reviewed indicate that early principal payments will result in lower interest expense and lower monthly payments.

The loan program you're considering may have a minimum-payment requirement equal to the initial monthly interest expense. If that's the case, any additional principal payments should cause future minimum payments to have both an interest component and a principal component.

The bottom line is that the interest charges are at a contractual rate based on the outstanding balance, and lower balances mean lower interest expense. Ask your lender to explain the loan agreement so you understand how principal repayments affect your loan balance and interest-expense charges.

The table below shows a conventional 30-year mortgage compared to a 10/1-interest only (I.O.) adjustable-rate mortgage (ARM). To make it an apples-to-apples comparison, you need to consider what you will do with the difference in mortgage payments.

I show two alternatives, one where you use the difference to pay down the mortgage and a second where the money is invested earning an after-tax yield of 4 percent. Both choices are an improvement over the conventional fixed rate option. The problem lies in your ability to commit to investing the payment differential, regardless of which option you choose.

If you're looking at an interest-only mortgage because you want to free up money in your household budget for other expenses then it's not very likely that you will be making additional principal payments or investing the difference. After 10 years of interest-only payments your loan will convert to a one-year ARM with a 20-year amortization.

Although using an interest-only mortgage for a refinancing may not be the right choice for you, there are situations where they can make sense.

-- Posted: Aug. 13, 2002