Question: With interest rates on the rise we are looking for a cheaper mortgage and lower monthly costs. One lender has suggested we consider interest-only financing. What are the pros and cons for such loans?
Answer: With interest-only financing the borrower has a far smaller monthly payment at the start of the loan term. However, interest-only mortgages have features which could potentially make them riskier than other loan options.
Let’s imagine that you want to borrow $160,000. You have your choice of a fixed-rate mortgage, an adjustable-rate mortgage (ARM) or interest-only financing. Assume that the interest level for the fixed rate mortgage is 4.17 percent while the ARM is priced at 3.39 percent and the interest-only product has a 3.625 percent start rate.
The ARM is a 5/1 mortgage, meaning the rate is fixed for the first five years after which the rate and monthly payment can adjust up or down, depending on changes to mortgage rates.
The interest-only loan is a 7/23 product; that is, the monthly rate and payment are fixed for the first seven years, after which the loan becomes an adjustable-rate mortgage where the rate and payment can change every year. The loan is interest-only for the first ten years after which it becomes self-amortizing. The interest rate can never be less than 2.5 percent.
If you look at these loan options you can see that each has an initial fixed rate and a fixed monthly payment. The numbers look like this:
- The fixed rate mortgage has a monthly cost for principal and interest of $779.63 for the life of the loan. This cost never changes.
- The 5/1 ARM has a monthly cost for principal and interest of $708.68 during the first five years of the loan term. After five years the interest rate can rise or fall, which means that monthly payments can also potentially rise or fall.
- The interest-only mortgage has a fixed payment for the first seven years of the mortgage. The initial monthly payments are interest-only, there is no reduction in the size of the debt. The initial monthly payment is $483.33. In years seven through ten of the mortgage, the interest rate can adjust but the borrower is only required to make interest-only payments. In years 10 through 30, the borrower must repay the loan with fully amortizing payments, payments which can be substantially higher than the original monthly expense.
If the only issue here was cutting down the monthly payment, then the interest-only mortgage would be attractive. However, buried in these loan options are other considerations.
First, the fixed-rate mortgage is a financial rock of stability. Once you have the loan, the monthly cost for principal and interest will not change.
Second, with the 5/1 ARM the borrower has set payments for the first five years of long-term and then monthly costs can rise or fall annually as rates change. Like the fixed-rate mortgage, the 5/1 ARM is a self-amortizing mortgage which means that each monthly payment includes both interest and some money to reduce the debt.
Third, the interest-only mortgage has a fixed rate and fixed monthly payments for the first seven years of the loan term. In years eight, nine, and ten, the monthly payment can adjust, which also means the interest-only monthly payment can move up and down. In years 11 through 30 the borrower must repay the loan with fully-amortizing monthly payments.
Fourth, since there is no required principal payment during the first ten years of the interest-only loan, the entire monthly payment is all interest and therefore likely to be entirely deductible.
The interest-only payment is also likely to represent a bigger deduction than borrowers would get with either a fixed-rate loan or 5/1 ARM. Speak with a tax professional for specifics.
Fifth, with the interest-only mortgage product the original debt remains after ten years. Instead of 30 years to repay the debt (the amount of time you’d get with a fixed-rate mortgage or ARM), only 20 years remain.
If the interest-only rate falls after ten years that’s good news. But what if the rate remains the same or rises a full five percent, the highest amount possible with the loan cap?
If the rate continues at 3.625 percent for the remainder of the loan term, the monthly payments will be $938.25 for principal and interest. However, if the rate rises to 8.625 percent the monthly payment can rise to $1,401.20 — not far from twice the fixed-rate payment of $779.63.
Borrowers might think that the higher monthly costs which are possible in the future for both the ARM and the interest-only mortgage are not a concern because they expect to sell the house in ten years or so, the typical term of ownership. Or, they might think that in the future their income will go up and that higher payments will not be a problem.
They might also think they’ll be able to switch to a fixed-rate loan format.
All of these are possible, but there are other considerations as well. There is no guarantee that future incomes will increase or that today’s credit level can be maintained. Also, the value of the property might decline, meaning that it will be difficult, if not impossible, to refinance the home without bringing cash to closing.
Every borrower must decide their own level of risk. For some borrowers, the lower up-front costs represented by interest-only financing will be enough to make the loan attractive. For others, the benefits of interest-only mortgages will be offset by the significant long-term risk such financing can represent. The choice is yours.