It’s Your Money Column – the Straight Skinny on Interest-Only Mortgages

Question: Should I refinance my mortgage with an interest-only adjustable mortgage? I’ve been told that I could retire when I’m 50 if I would refinance and invest the difference.

Answer: The financial planners that I have checked with are not in favor of interest-only mortgages for most people. There are risks associated with this type of mortgage that must be evaluated before making a decision.

When a borrower finances a home with a conventional mortgage, a portion of each monthly payment pays the interest on the loan and a portion goes toward reducing the principal of the loan. If the borrower makes monthly payments for the entire loan, usually 15 or 30 years, they own the home free and clear. An interest-only mortgage requires the borrower to pay only interest for an initial period of the loan, often 5 to 10 years, and then pay larger payments for the remainder of the loan. If, for example, you had a $100,000 loan at 6.25 percent interest for 30 years, your monthly payment would be $615.72 – $520.84 for interest and $94.88 to pay off the principal. The borrower with an interest-only loan would pay $520.84 each month because none of the payment was reducing principal. At year 11, the payment would increase to $730.93 per month for the remaining 20 years.

What are the risks of an interest-only loan?

1. The monthly payments will be larger in the future. Borrowers will have to make higher payments for the remaining 20 years of the loan to pay off the balance.

2. An increased risk occurs if the loan has an adjustable-rate. Interest rates for adjustable-rate loans change, and many people predict that interest rates will continue to rise. At the end of 10 years, higher interest rates could further increase the monthly payments.

3. Refinancing requires closing costs. If closing costs are added to the current mortgage, the principal is larger and there is more to repay over the life of the loan.

4. Interest-only loans often have a higher interest rate than other mortgage loans.

5. If housing prices fall in 10 years and you need to sell your home, you will have to come up with additional cash to pay off your loan balance because the sale won’t cover the loan principal.

One of the benefits suggested for interest-only loans is to invest the difference in payments. The individual who does this must be disciplined enough to actually invest the difference rather than spending it and must know how to get a return on their money that would exceed the interest rate of their mortgage.

Jack Guttentag, professor emeritus at the Wharton School of the University of Pennsylvania, says, "With the stock market in the tank and most short-term rates below 2 percent, mortgage loan repayment is the best investment available to most homeowners."

If you are thinking about an interest-only mortgage, go to Jack Guttentag’s Web site at www.mtgprofessor.com and use the tutorial to personalize your information. A voluntary contribution is requested to support his work.

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Judy McKenna, Ph.D., CFP, Family Economics Specialist, Colorado State University Cooperative Extension, mckenna@cahs.colostate.edu

491-5772