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Interest only loans have become increasingly more popular over the last several years. This type of mortgage allows the borrower to pay “interest only” as their mortgage payment.
The result is usually a lower mortgage payment, because the borrower is not paying anything towards the principle on the loan. This means that if your original loan was $200,000 after five years of interest only payments you still owe $200,000.
The question we will examine today is whether or not this type of loan is a good option for the consumer.
Proceed With Caution
First, let me start by saying in my opinion, if you are using an interest only loan to afford more house you are placing yourself in a dangerous situation (financially speaking).
More times than not, people will use an interest only loan because they cannot afford the 30 year fixed payment on the home they are considering. Approaching home ownership and your finances in this way will likely result in carrying debt for your entire life.
As responsible financial consumers our goal should be to eliminate our debt at some point in our life.
It Works For Some Homeowners
So how could an interest only loan actually help you get your home paid off more quickly than a conventional mortgage?
The advantage to the interest only loan is the low payment. This frees up extra money to save outside of the mortgage. If you were able to invest this extra money in some type of side investment, you would be growing an account that could be used to pay the remaining principle off in a lump sum at some point in the future.
Let’s take a look at how I manage my mortgage. I calculated what a 15 year fixed payment would be on my home mortgage. I then calculated what an interest only payment would be on that same amount. I took the difference between these two numbers which became my side investment.
I took out an interest only loan and presently save the difference in a side investment. Does this make sense? The short answer is, it depends. It depends on what interest rate you are borrowing the money at, and what interest rate you are earning on your side investment.
I am borrowing the money at 5%. After my tax write-off for the interest portion (which is all of it) my real borrowing rate is 3.75%. Remember, the government gives us a tax break on the interest we pay on a mortgage for our primary residence.
If I am able to earn more than 3.75% in my “side investment” then I am coming out ahead by using an interest only mortgage and investing the difference. If I am earning less than 3.75% then I am better off putting those extra payments onto the principle of the home loan.
A Few Things To Consider
My interest rate is only locked for five years. That means that at some point in the future my rate will change and I will have to refinance. This presents some risk, given that interest rates could be significantly higher in the future.
Also, the question should be raised – Am I better off locking in a low interest rate for 30 years on a conventional mortgage if interest rates are at historical lows?
What if the opposite were true? If interest rates are at historical highs, should I be locking long term or shorter term?
In the latter, if interest rates are high and we expect them to drop in the future it may be wise to lock for a shorter period such as 3-5 years and then lock longer terms once rates drop.
The bottom line is that interest only loans can be an effective tool in managing and even paying off your home mortgage. However, they are often abused and used for the wrong reason.
I recommend that you DO NOT take out an interest only loan unless you are simultaneously working a plan to pay off the principle on that same loan. Logically work through these types of questions before taking out a loan.
Do not simply take a mortgage officer’s “word for it.” Your gut instincts will often steer you in the right direction.
I’m a Financial Consultant and Personal Financial Representative with experience in financial analysis, strategic planning, presenting, & financial advisory services.