Interest-only loans John Mazzarainterest-only payments, fixed interest rate, Fannie Mae
A lot of the press today states that interest-only loans are bad
and that they should be avoided. Instead, let's examine why you
might want to get an interest-only loan. Once you understand how
the typical product works, you can make your own educated decision.
Think of your mortgage as a financial instrument that needs to be
managed and integrated with your other financial goals.
A conservative example of an interest-only mortgage product
allows for 10 years of interest-only payments. The repayment period
of the loan is traditionally 30 years. The interest rate is fixed
during the entire 30-year repayment period. This loan is offered
through lenders selling to Fannie Mae, which is a
government-sponsored entity. They are very large and a significant
purchaser of loans, so you shouldn't have too much trouble finding
this loan. Most Mortgage Brokers will be able to offer it to
you.
This loan product allows the first 10 of the 30 years to have
payments based on just repayment of the interest, or interest-only.
After the initial 10-year period, the outstanding remaining
balance, often the same as it was in the beginning, needs to be
amortized and paid off. You now have a 20-year loan, which
represents the remaining time left on the mortgage. The interest
rate remains the same as the initial rate. There was no change in
the interest rate. There is no interest rate risk. The only
variable that changes is the amortization period, having gone from
30 to 20 years. If you want interest-only payments again, simply
refinance. In fact, there are no prepayment penalties to pay off
this loan.
How can an interest-only mortgage be a good thing? Your mortgage
payments are less than a traditional amortizing loan. The actual
payment differential is about $100 per $100,000 borrowed. This
means you can get the home you want for a lower payment. This
allows you to allocate the savings in payments into other places.
One good place might be your retirement plan. For example, maybe
you are not taking advantage of a retirement plan at work or the
employer match. Salary deferred into a retirement plan is generally
on a pre-tax basis. This allows you to pick up the differential in
dollars that would have been lost to taxes. Instead, these
tax-deferred dollars are compounding in your retirement plan. If
you are able to pick up the employer match where you hadn't before,
you effectively are earning up to 100 percent on your deferred
dollar, assuming the match is dollar for dollar.
Interest-only payments enable you to buy a larger home with the
payment you find comfortable. This generally translates into 20
percent more of a home for the same monthly payment. This extra 20
percent of buying power might allow you to buy up to what you
really want. Getting more of what you need in a home will allow you
to remain in that home longer and build more equity. Moving often
may strip you of a lot of your potential equity, due to the costs
involved in buying and selling a home.
You can't deduct principal. At the end of the year, your lender
will send you a 1098. This form represents the amount of interest
that you've paid in the previous year. This is what you may be able
to deduct on your taxes. Principal repayment is never deductible
and may actually accelerate the loss of your tax deduction, such as
mortgage interest, by reducing the outstanding mortgage balance
from which interest is calculated.
You may be able to earn a higher rate on your invested funds
than the rate you are able to borrow money at for a mortgage. This
is mortgage interest rate arbitrage. This is why you might want to
borrow as large a mortgage as you feel comfortable maintaining and
invest your equity somewhere else. Following this strategy, you are
doing the same things that banks and insurance companies
participate in. Last time I looked, it worked pretty well for
them.
Your equity, due to appreciation, grows the same
way—regardless of how you finance a home. Equity growth is
based on the appreciation of the underlying property. Consider
this: If you can buy more of a home with an interest-only loan, and
if all homes appreciate by the same percentage, then you will gain
more equity from the home that initially costs more. The equity
that you are building through amortization by paying down on a
mortgage is really just a forced savings plan. It may be possible
to take these payment savings that you pay into the forced savings
plan and instead invest them into some alternative investment that
will appreciate at a higher rate. If you should want your home paid
off or paid down in the future, simply liquidate this alternative
investment and apply it to your outstanding mortgage balance.
What are the negatives? You might be able to argue the other
side of the advantages I've outlined, but I think you would be
remiss. For example, you could argue that there are no alternative
investments that offer a higher rate than the net rate you're
paying on your mortgage based on the risk you are willing to take.
This might be the case for the most conservative. If that's the
case, I still think the other advantages provide enough reasons to
consider an interest-only loan. To be objective, there might be one
risk to consider. If you don't think you can make the mortgage
payment after the interest-only period, and you feel that in the
future you might not be able to refinance or sell your home, for
whatever reason, then you should stick with a traditional 30-year
fixed conventional loan.
John Mazzara, CMB is president of Venture Development Inc.
He may be reached at (952) 929-2577 or e-mail
[email protected].
