Mortgage on an investment property

Dear Dr. Don,
My husband and I own our condo outright (no mortgage), which is our primary residence. We want to buy a condo at a beach near us for an investment. With all the mortgage products available, we don't know which way to turn.

We considered a HELOC to save closing costs and the interest-only payment is tempting. A home equity loan is another possibility, but the rates are higher (I'm not sure why). Or, we could get a conventional 15- or 30-year fixed mortgage since we don't have one. Should we also consider a Monthly MTA? I have been all over the Bankrate site and still can't pinpoint our best bet. Could you please make some comparisons or possible scenarios? Thanks so much.
-- Lyndy Loan

Dear Lyndy,
Home equity loans carry a higher interest rate because they are a fixed-rate loan vs. the variable rate on a HELOC (home equity line of credit). The lender shoulders the risk that interest rates head higher, not you.

An MTA mortgage is an adjustable-rate mortgage where the interest rate is set at a spread or margin to the 12-month Treasury Average Index. Bankrate's Rate Watch feature tracks this rate. Introductory rates and flexible payment options make this type of mortgage appealing to homeowners or investors looking to minimize payments over the short-term on a property. I'm not a fan, but if you go this route make sure you understand the possibility of negative amortization and the interest reset provisions on the mortgage.

For an investment property, you want to manage the expected cash flows and tax effect of owning the property. An interest-only loan will keep the monthly payment low, but you only build equity in the property by seeing the value of the condo increase. Decisions you make about how the property is managed and maintained, and decisions about depreciating the property will all influence the property's cash flows. Work with your tax professional to decide on an approach to financing, managing and depreciating the property that is best for you.

Condominiums, even beachfront condos, can be tricky as investment properties. Since you're already condo owners you have a better perspective on this than someone that has never owned one, but the economics of an investment property are different.

Over the past several years, variable-rate loans have been a smarter choice than fixed-rate loans, but that's because the Federal Reserve had been putting downward pressure on short-term interest rates by lowering the federal funds rate. Going forward, there's not much room for rates to head lower and plenty of risk that rates will head higher.

What's your expected holding period? The longer you plan to own the property, the more sense it makes to have a fixed-rate loan, especially in the current interest rate environment. You'll have a higher interest rate than on the HELOC, and you'll be making both principal and interest payments, but you'll be sure that the mortgage rate won't head higher. A 5/1 or 7/1 adjustable-rate mortgage is a compromise between the two extremes and should be available on an interest-only basis.

Manage your risks over the life of the loan vs. just looking at what the low-cost solution is today.

-- Posted: Aug. 18, 2004