Dear Dr. Don,
I plan to buy a second house next year. My first house will be paid off in less than five years. So I plan to combine the first house loan with the second house loan.
I checked that if I use an interest-only mortgage, the interest rate is lower than for a 30-year fixed-rate mortgage. I am, however, a frugal person, so I plan to pay more every month on the top of the interest to get the loan principal lower while saving on interest.
Do you think this is a good idea?
I’m not sure what step in this investment you want me to validate. Do I think you’re making the right move in buying a second home? I don’t know enough about your local real estate market to help you. Is it a rental, a vacation home, a retirement property or just a speculative investment? You’ll have to wrestle with that decision on your own.
Do I like interest-only loans? They have their place. Most interest-only loans are hybrid adjustable-rate mortgages, or ARMs, like a 5/1, 7/1 or 10/1 interest-only ARM. You’re getting a lower interest rate on these mortgages versus a conventional 30-year fixed-rate mortgage because you’re shouldering the interest rate risk when the loan resets five to 10 years from now.
Should you make additional principal payments? My rule of thumb is that you make additional principal payments when the after-tax return on your investments is expected to be less than the effective (after-tax) rate of return on your mortgage.
Deciding whether to prepay a mortgage depends upon what’s going on in your overall portfolio of investments, along with your attitude toward risk and your plans for retirement.
Should you combine the mortgage on your first house with the mortgage on the second home? It can make sense if it lowers your total interest expense on the homes. There may be a sound business reason to keep them separate if your second home is a rental property.
Interest-only loans make the most sense for homeowners with variable income that want some flexibility on when they pay down principal, or want to buy more house then they can afford with a conventional fixed rate mortgage. You don’t appear to be in either of these camps.
Justifying the interest-only mortgage based on the difference in interest rates between an interest-only ARM and a conventional fixed-rate mortgage means you’re willing to make a bet on where interest rates are heading between now and the reset period.
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