Dear Dr. Don,
I recently purchased my retirement home, a place in the country. The home I'm moving from is in a booming city, where real estate values are skyrocketing. I am considering an interest-only loan for the home I'm moving out of since it will be a rental property while property values escalate. Is this a good idea?
-- Linda Loan

Dear Linda,
You paint a nice picture of what will happen to the value of your former home when you make it into a rental property after you move into your retirement home. It's hard to forecast where real estate prices will head over time, but my mantra is "no tree grows to the sun."

Because I can't tell you whether the rental property will continue to increase in value, let's focus on your question of whether it's a good idea to refinance the rental property with an interest-only loan. What's good about the interest-only loan is that you aren't paying down the principal balance over at least an initial portion of the loan term. That improves the monthly cash flow on the property and keeps the mortgage interest expense constant over time.

A common interest-only structure is a 5/1 or 7/1 adjustable rate mortgage, or ARM. Fixed-rate interest-only mortgages are available -- the typical interest-only loan is not interest-only for the life of the loan, just over an initial term. At the end of that initial term, the loan payment will be recalculated to include the repayment of principal.  Because the principal repayment takes place over fewer years, there can be a big jump in the monthly mortgage payment. My advice is for you to find a mortgage with an interest-only term that matches your expected holding period for the rental property.

Example

Interest-only mortgage Conventional financing Difference Mortgage $200,000 $200,000   Interest rate 6.5% 6.5%   Monthly payment $1,083.33 $1,264.14 $180.80

The other side to this, as shown in the example above, is that the difference in the monthly payment on an amortized loan for $200,000 and an interest-only loan at the same interest rate is only $180.80. That's just $91 per $100,000 loan. Compare interest rates on the fixed rate conventional mortgage and the interest-only financing before deciding that interest-only is the way to go. A low fixed-rate conventional mortgage versus a 5/1 or 7/1 interest-only ARM can eliminate some interest rate risk, allowing you a longer holding period without worrying about the interest rate reset.

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