 Refinancing
into an interest-only mortgage
|
 Dear
Dr. Don,
I own a home in the 20176 ZIP code, worth $500,000. I owe $300,000
on the first mortgage and $80,000 on the second mortgage. I plan
to be there another 15 years, but I need money now in pocket.
What is an interest-only loan? I think I should do
this for $400,000 to get out of debt and have more monthly money?
Thank you,
-- Nan Notes
 Dear
Nan,
OK, you got me to look. You live in the Greater Washington, D.C.,
metropolitan area, somewhere in or around Leesburg, Va. I spent
a few years in Northern Virginia myself in the late 1980s. I hated
the traffic then, but I'm sure it was positively bucolic when compared
to the traffic today.
Replacing $20,000 in debt with $20,000 in mortgage
debt isn't getting you out of debt; it's just restructuring your
debts. Replace credit card debt with interest-only mortgage debt,
and you're postponing repaying that debt as well, so it's keeping
you in debt longer.
You didn't say your debt was credit card debt, but
I'll make that assumption. If you turn around and run up those lines
of credit all over again, any relief you feel in your monthly budget
will be short-lived.
The monthly mortgage payment for a conventional fixed-rate
mortgage is self-amortizing. That means 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.
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 might offer other options. Matching the time you plan
on being in the house with the initial rate on the interest-only
loan isn't feasible in your case, since you expect to be in the
house 15 years.
Restructuring your debt to interest-only debt can
free up some financial slack in your monthly spending plan, but
that slack comes at a pretty big price. You'll take on the interest
rate risk of an adjustable-rate loan, the closing costs associated
with a new first mortgage and stop paying down your loan balances.
The table below contrasts the change in mortgage related expenses
between doing a cash-out refinancing with a new 30-year fixed rate
mortgage and using a 7/1 interest-only ARM.
|
30-year fixed |
7/1 Interest-only ARM |
Difference |
| Loan amount: |
$ 400,000 |
$ 400,000 |
|
| Interest rate: |
6.120% |
5.625% |
|
| Monthly payment: |
$ 2,429.15 |
$ 1,875 |
$ (554.15) |
| After 7 years: |
|
|
|
| Total payments: |
$ 204,048.51 |
$ 157,500.00 |
$ (46,548.51) |
| Interest expense: |
$ 163,368.73 |
$ 157,500.00 |
$ (5,868.73) |
| Loan balance: |
$ 359,320.21 |
$ 400,000.00 |
$ 40,679.79 |
You free up roughly $550 per month in your monthly budget with
the interest-only loan. You've also reduced your interest expense
by about $6,000, with the lower interest rate on the loan, but have
done nothing about paying down your loan balance. (I've ignored
any impact on your income-tax deductions.)
I wouldn't recommend this approach unless you were up against it
in meeting your monthly bills. Even then, using a second mortgage
can be an easier approach than totally restructuring your debts.
Keep in mind you'll pay a few thousand dollars in closing costs
to get a new first mortgage and only a few hundred to get a new
second mortgage.
Spending thousands to restructure $20,000 in nonmortgage debt
doesn't make a lot of sense. If a little budgeting and belt tightening
can get you though this, and the interest rates on your existing
loans mean that refinancing wouldn't make sense on its own merits,
then look at getting a second mortgage instead.
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