Is Interest Only Right For You?

Posted January 29, 2008

Over the past few years, lenders have pushed their “interest only” mortgage loans. In many cases it was sold as a way to afford more home. But in all reality, is an interest only mortgage loan right for you?

To determine an interest only mortgage’s fit for your life, we must first examine what an interest only mortgage is. In layman’s terms, and interest only mortgage loan is one in which you are only billed for the interest due. In a normal conventional mortgage, the monthly payment normally consist of both principal and interest payments. To further explain the differences, let’s look at an axample:

A traditional mortgage: 250,000 mortgage loan @ 6% interest over 30 years requires $1498.88 (plus taxes, insurance and any PMI). When you make the first payment, $1,250 is paid towards interest, and $248.88 is paid towards the principal balance. This leaves a balance of $249,751.12. So the second payment reduces the interest portion to $1,248.76 while increasing the principal payment to $250.12. Over the next 30 years, the mortgage will slowly pay itself down in this manner.

An Interest Only Mortgage: Same $250,000 @ 6% interest with a 30 year term would look a bit different. The monthly payment would only be $1,250. This is $248.88 less that the traditional mortgage, but note that nothing is contributed towards the mortgage balance. The balance will remain at $250,000 until you make more than the interest only payment. Majority of 30 year interest only mortgage loans have a 10 year life to the interest only portion. That mean that beginning in year 11, you will be required to make principal and interest payments each month, however they will be calculated on the remaining 20 years. So if your balance in that 11th year is still $250,000, your new principal and interest payment will then be $1,791.08.

So, does that make interest only loans bad? No. Interest only loans are a great option if they are the right option for you. Knowing if it is right makes all the difference.

First off, don’t use an interest only product to try and afford more home than you can afford. Most lenders will still qualify you on the full payment, so this may not even be an option any more. However, even if you qualify at the full payment, if that full payment is more than you can comfortably handle, either put more down or buy a lower priced home. Do not use interest only to “afford” it. Eventually, you become so used to that payment that when it changes, and it changes big time, you can no longer afford your home.

Second, what will you do with the savings? This is a serious question. If you are eyeing a plasma tv, or this could help you save for a vacation, again buy a smaller home. The savings on your interest only payment should not be used for discretionary things. Remember, you are robbing Peter to pay Paul with an interest only loan. You will have to pay for this eventually. The savings should be put towards things that really matter in your life. Pay off credit card debt, student loans and other bills. Put the money in a long term investment that will pay you greater dividends, maybe something earmarked for retirement or your kid’s college fund. But don’t waste the money on a tv or furniture just to impress others. That stuff will soon need to be replaced again, and you will have nothing real to show for it.

Third and finally, “know thyself.” The bottom line is that you know how you are. They claim the road to hell is paved with good intentions. Well, so is the road to debt. Your best intentions to “hope to pay off debt” cold easily be swayed towards that emergency purchase of the plasma tv “on sale!” If you are not disciplined to handle your money properly and do not have an established budget that you work and live by, don’t do the interest only mortgage. You will only hurt yourself in the long run.

I hope this helps you to decide if the interest only mortgage is right for you. This product is a tremendous product with great potential, in the right hands. A borrower that has a good amount of equity in the home, can manage to use the monthly savings in an effective way and someone that really knows they can handle it can do very well with this product. However, someone looking to buy more home than they can afford, wanting to save the money to buy all the “stuff” to fill the house, or someone trying to rationalize it in their own head should stick with a traditional principal and interest mortgage loan. Choose the mortgage loan that is right for YOU, not the home loan the lenders feel like pushing this month!

Category Posted in Buying a Home, Credit Tips, Mortgages, Refinance