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Ask Dr. Don

Interest-only mortgages

Dear Dr. Don,
I currently have a 30-year fixed-rate mortgage at 6.875 percent and variable-rate home equity line at 7.55 percent. I have been paying on the mortgages for two years. I owe $155,000 on the 30-year mortgage and $21,000 on the equity line. My payments are $1,051 for the mortgage and $325 for the equity line. Is a variable rate or interest-only loan a good choice for me?
Maurice Mortgages

Dear Maurice,
Seeing mortgage rates go higher over the past few months has people trying to finesse new financings to get mortgage payments comparable to the lows of this spring. Taking on interest-rate risk and hoping that the Fed will keep the fed funds rate low, allowing other short-term rates to remain low, is mostly wistful thinking. So is not making principal payments by using an interest-only loan.

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A variable-rate mortgage is priced at a spread to an interest rate such as the 11th District Cost of Funds, or the one-year Treasury Constant Maturity. (Use Bankrate's Rate Watch feature to follow changes in these rates.) The rate resets periodically adjusting to changes in the underlying interest rate. The homeowner takes on the risk that his mortgage rate will increase over time. Since the homeowner shoulders this risk, the bank doesn't have to try and price this risk in the mortgage rate.

Variable rates work best when short-term interest rates are expected to stay the same or go lower. A lower interest rate on your mortgage means that more of your monthly payment goes toward principal repayment. A lower monthly payment can also free up enough money in your budget to make additional principal payments.

An interest-only loan reduces the required monthly payment by taking out the principal component. You can qualify to buy a more expensive home because of the lower front-end ration.

This type of mortgage is used when you're not interested in increasing your equity in the home beyond your down payment and any increase in the home's market value over time, or you want to stretch to buy a bigger home than you can currently afford but expect your annual income to increase over time to the point where you will be able to pay down the principal on the home. It's also useful for people who get a high percentage of their annual incomes as bonuses or in commissions. This Bankrate feature has more information about interest-only mortgages.

The longer you expect to be living in the house, the more sense it makes to have a fixed-rate first mortgage. Bankrate has a mortgage adviser function that can help you determine if a fixed-rate or variable-rate mortgage is right for you.

I'm a little perplexed why the variable rate on your home equity line is so high. Take a look at your loan documents and see how that rate resets. Depending on the strength of your credit report and the prepayment provisions on this loan, you may be able to do much better by refinancing this loan at fairly modest closing costs.

-- Posted: Sept. 16, 2003

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See Also
Interest rises in interest-only loans
10 biggest home buying mistakes
Financial advice glossary
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