Interest-only loan vs. conventional financing

Interest-only loan vs. conventional financing Ask Dr. Don by Don Taylor, Ph.D., CFA, CFP • Bankrate.com Dear Dr. Don, I am interested in purchasing a home and trying to keep my mortgage payment as low as possible. The mortgage lender I am working with has suggested an interest-only mortgage for the first five years and then refinancing after that. I would still put $500/month toward principal. Would I pay less interest in the long run than if I had struggled with the monthly payments with a conventional mortgage from the start? -- Laurie Limits - advertisement - Dear Laurie, The monthly mortgage payment for a conventional fixed rate mortgage is self-amortizing. That means that the monthly payment contains both the monthly interest expense and a contribution to principal that allows the mortgage to be paid off over the life of the loan. An interest-only mortgage doesn't have the principal repayment component, at least not in the early years of the loan, so it allows you to minimize your monthly mortgage payment. An interest-only mortgage can help a homeowner qualify for a bigger house or free up funds for other purposes, like investing. Interest-only mortgages are commonly adjustable-rate mortgages, or ARMs, but they can also have a fixed initial term. Bankrate provides quotes on 3/1, 5/1 and 7/1 interest-only ARMs, but lenders may offer other options. I've put together a scenario that compares an interest-only mortgage with additional principal payments versus a conventional 30-year mortgage over a five-year horizon when you pay down $500 per month in principal on the interest-only loan. The problem is that it isn't quite an apples to apples comparison because you're paying $1,541 per month with the interest-only loan and only $1,231 per month with the conventional mortgage. What are you doing with the extra $310 per month if you take out a conventional mortgage? In the last column of the table I use the $310 per month to make additional principal payments. That brings down the principal balance. Since I'm using the same interest rate for both the 5/1 ARM and the conventional fixed-rate loan, most of the difference deals with the declining loan payment on the interest-only loan. Interest only with additional principal payments Conventional mortgage Conventional plus additional principal payments Loan amount: $ 200,000 $ 200,000 $ 200,000 Interest rate: 6.25% 6.25% 6.25% Loan term (months): 360 360 360 Loan payment: $ 1,041.67 * $ 1,231.43 $ 1,231.43 Additional principal: $ 500.00 N/A $ 310.23 Total monthly payment: $ 1,541.67 $ 1,231.43 $ 1,541.67 Total payments over 60 months: $ 87,389.93 $ 73,886.06 $ 92,500.16 Total interest expense over 60 months: $ 57,389.93 $ 60,560.55 $ 57,389.95 Loan balance: $ 170,000.00 $ 186,674.48 $ 164,890.09 * The interest-only payment declines over time because of the additional principal payments. What does all this mean? Well, if you're planning to make additional principal payments each month on the interest-only loan, that takes away one of the reasons for using an interest-only loan. It does give you a measure of flexibility, however, since the $500 per month payments aren't contractual, and that can be a consideration. If there was a big rate differential between a 5/1 interest-only ARM and a 30-year conventional fixed-rate mortgage, you could make the argument that you're paying a lower interest rate on the loan and that frees up funds to make those principal payments. That isn't the situation in the current market. As I write this, Bankrate's national average for a 30-year fixed rate loan is 6.32 percent, and a 5/1 interest-only ARM, at least in my market, is right on top of that rate. Planning to refinance the interest-only mortgage five years from now is both a dicey and expensive proposition. Who knows where interest rates will be, and why take on $2,000 to $4,000 in closing costs to get out of the interest-only loan if you can afford to be in the fixed-rate loan today at what is historically a very attractive rate? The Bankrate feature, "Closing costs averages comparison," has more on closing costs. How long you plan to be in this house is also a consideration. A five-to-seven year horizon means you definitely don't want to be refinancing five years out and you should, at a minimum, be looking at 7/1 interest-only ARMs.