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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.
Darcy Decision

Dear Darcy,
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.

30-year fixed Interest-only
LIBOR ARM
Difference
Initial interest rate: 5.67% 3.20%  
Loan amount: $ 200,000 $ 200,000  
Loan term in months: 360 120  
Initial payment: $1,157.00 $ 533.33 $ 623.67

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.

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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 up, too.

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

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See Also
Interest-only mortgages
Getting out of an interest-only loan
Financial advice glossary
More Dr. Don stories

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National Mortgage Rates
OVERNIGHT AVERAGES
Rates may include points.
30 yr fixed mtg 4.12%
15 yr fixed mtg 3.14%
5/1 jumbo ARM 3.61%



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