 Interest-only
loan vs. conventional financing
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 Dear
Dr. Don,
I am interested in purchasing a home and trying to keep my mortgage
payment as low as possible. The mortgage lender I am working with
has suggested an interest-only mortgage for the first five years
and then refinancing after that. I would still put $500/month toward
principal. Would I pay less interest in the long run than if I had
struggled with the monthly payments with a conventional mortgage
from the start?
-- Laurie Limits
 Dear
Laurie,
The monthly mortgage payment for a conventional fixed rate mortgage
is self-amortizing. That means that the monthly payment contains
both the monthly interest expense and a contribution to principal
that allows the mortgage to be paid off over the life of the loan.
An interest-only mortgage doesn't have the principal repayment
component, at least not in the early years of the loan, so it allows
you to minimize your monthly mortgage payment. An interest-only
mortgage can help a homeowner qualify for a bigger house or free
up funds for other purposes, like investing.
Interest-only mortgages are commonly adjustable-rate
mortgages, or ARMs, but they can also have a fixed initial term.
Bankrate provides quotes on 3/1, 5/1 and 7/1 interest-only ARMs,
but lenders may offer other options.
I've put together a scenario that compares an interest-only
mortgage with additional principal payments versus a conventional
30-year mortgage over a five-year horizon when you pay down $500
per month in principal on the interest-only loan. The problem is
that it isn't quite an apples to apples comparison because you're
paying $1,541 per month with the interest-only loan and only $1,231
per month with the conventional mortgage. What are you doing with
the extra $310 per month if you take out a conventional mortgage?
In the last column of the table I use the $310 per
month to make additional principal payments. That brings down the
principal balance. Since I'm using the same interest rate for both
the 5/1 ARM and the conventional fixed-rate loan, most of the difference
deals with the declining loan payment on the interest-only loan.
What does all this mean? Well, if you're planning
to make additional principal payments each month on the interest-only
loan, that takes away one of the reasons for using an interest-only
loan. It does give you a measure of flexibility, however, since
the $500 per month payments aren't contractual, and that can be
a consideration.
If there was a big rate differential between a 5/1
interest-only ARM and a 30-year conventional fixed-rate mortgage,
you could make the argument that you're paying a lower interest
rate on the loan and that frees up funds to make those principal
payments. That isn't the situation in the current market. As I write
this, Bankrate's national average for a 30-year fixed rate loan
is 6.32 percent, and a 5/1 interest-only ARM, at least in my market,
is right on top of that rate.
Planning to refinance the interest-only mortgage five
years from now is both a dicey and expensive proposition. Who knows
where interest rates will be, and why take on $2,000 to $4,000 in
closing costs to get out of the interest-only loan if you can afford
to be in the fixed-rate loan today at what is historically a very
attractive rate? The Bankrate feature, "Closing
costs averages comparison," has more on closing costs.
How long you plan to be in this house is also a consideration.
A five-to-seven year horizon means you definitely don't want to
be refinancing five years out and you should, at a minimum, be looking
at 7/1 interest-only ARMs.
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