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Are Interest-Only Loans Legit?

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Posted On: 04/27/2016

QUESTION:

Before the mortgage meltdown it was possible to get interest-only financing. I thought such mortgages had gone away, but our lender says they’re still available. Why are they still allowed and why would I want one?

ANSWER:

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An interest-only mortgage is a form of financing that may be attractive to some borrowers because it offers up-front monthly savings. Properly underwritten, it’s simply another mortgage option. It works for some borrowers and not others.

Let’s say you want borrow $200,000 at 4 percent. With a fixed rate over 30 years the monthly cost for principal and interest is $954.83. The potential interest bill over the life of the loan is $143,739.

As an alternative, suppose you get a 5/1, interest-only, $200,000 mortgage. The loan is interest-only for the first five years and then converts to a one-year ARM for the remaining 25 years of the loan term.

In the first 60 months you pay only interest. At 4.75 percent the monthly payment is $791.66. Why 4.75 percent and not 4.00 percent? Because I checked rates with a lender who offered both products and found there was a .75 percent higher rate for the interest-only loan. Still, that’s a monthly cash savings of $163.17, or $9,790 over five years.

At the end of five years the interest-only period ends and we switch to an ARM format. For the sake of illustration let’s say the interest rate remains 4.75 percent.

We now have a $200,000 balance to be repaid over 25 years at 4.75 percent interest. The monthly cost for principal and interest is $1,140.23. The total potential interest cost for the loan includes the $47,500 paid during the first five years of the loan (60 x $791.66) plus $142,069 for the remaining 25 years, a total of $189,569.

We can see that the potential cost for the interest-only loan is $45,830 higher over 30 years. But how realistic is this example?

Will the loan last 30 years? Not likely. According to Freddie Mac, the typical loan is now refinanced after seven years, so the higher cost for the interest-only loan might not happen.

Will the interest-rate remain level once the financing converts from an interest-only status to an ARM? Again, not likely. The rate can rise or fall. If the rate falls that’s good news, but if the rate rises then the borrower must have the financial capacity to pay. For instance, if the rate rises to 6.75 percent in year six, the new monthly cost for principal and interest will be $1,381.82.

In comparing fixed-rate financing versus interest-only mortgages remember that loan balances count. At the end of five years our interest-only borrower still owes $200,000 while the fixed-rate borrower has reduced the debt to $180,895. Owing $19,105 less to a lender is surely a good thing.

The allure of interest-only financing comes from the initial monthly savings and the potential for lower costs if rates fall. That said, interest-only financing also involves the risk that rates and monthly payments can go higher and that the borrower owes more to the lender for a longer period of time.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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