||Ask Dr. Don
Evaluating a LIBOR-based, interest-only mortgage
Dear Dr. Don,
I have been approached by a lender suggesting that I refinance my
30-year fixed mortgage (5.375 percent) with a mortgage based upon
the six-month LIBOR with a 2 percent margin. For the first 10 years
no payment toward principal would be necessary. It would then revert
to a 20-year fixed mortgage.
This appears to be a good deal for a fiscally responsible
person. However, I am concerned it is too good to be true and want
to make certain that I am not missing something. What are the benefits
and pitfalls of these mortgages? Thank you for your time and expertise.
An interest only, adjustable-rate mortgage provides you with a rock
bottom monthly payment. What you do with all the money you free
up in your monthly budget largely determines whether this type of
mortgage is a good idea.
You can use Bankrate's "Rate
Watch" feature to track six-month LIBOR and other interest
rates. As I write this, six-month LIBOR is reported at 1.20 percent
making the LIBOR-based loan rate 3.20 percent. That compares with
a national average for 30-year fixed-rate mortgages at 5.67 percent.
|Initial interest rate:
|| $ 200,000
|Loan term in months:
As you can see in the above example, an interest-only mortgage
for $200,000 has a monthly payment about $625 less than the fixed-rate
mortgage -- at least until the first interest rate reset.
What the table doesn't show you is that the fixed-rate
mortgage payment has two components, the interest expense plus principal
repayment. In the first month's mortgage payment, $212 goes toward
principal reduction and $945 is the interest expense. As time goes
by, the monthly interest expense drops with the fixed-rate mortgage
until, 10 years later, the monthly payment is $785 interest expense
and $371 principal reduction and the loan balance is $165,873. Bankrate
has a mortgage
calculator that generates a full amortization schedule.
Still, the interest-only LIBOR base loan can offer
some real advantages in the early years of the mortgage if you use
the difference in payments to pay down your loan balance. Being
able to reduce your loan balance by $625 per month is almost three
times the monthly principal reduction in the fixed-rate mortgage
in the early years of that mortgage. Having the financial discipline
to make those payments, however, is crucial to that advantage since
the additional payment is at your option.
Making the additional principal payments also reduces the interest-rate
risk that you're taking on in the interest-only mortgage, although
that risk is still substantial. It reduces the risk by reducing
the loan balance that is charged any rate increase. LIBOR has to
stay low and you have to keep making the additional payments to
realize this risk reduction over time.
Don't count on being able to time the market and refinance
to a fixed-rate loan if things turn ugly when LIBOR starts to rise
because the interest rates on the fixed-rate loans will have gone
I think that interest-only ARMs make sense for people
that don't expect to be in the mortgage or house for a long time,
or for people who want to leverage an investment in a home, limiting
their equity in a property to the down payment plus any appreciation
they experience over time.
-- Posted: Feb. 26, 2004