Interest Only Loans

Long-term, I’d either sell or refinance and use the property as a rental. What do you think about using an interest-only loan for this purchase?
 

A: Interest-only loans are generally much less costly than regular loans because each payment is only the interest owed, without any principal. But depending on which interest-only loan product you choose, the interest rate can be lower or higher than a conventional fixed-rate or adjustable rate mortgage.

For example, a friend recently refinanced her interest-only loan and her new rate is 2.75 percent. But, she has a 6-month loan tied to LIBOR, which is a slow-moving index, and the loan can adjust every six months.

But if you want a 7/1 interest-only loan, you’ll pay a higher rate than a conventional 7/1 ARM.

I typically think of interest-only loans as being good for very short-term circumstances. For example, if you said you were going to live in your home for 6 months and then sell it, an interest-only mortgage might work out well.

But you’re clearly not thinking that short-term. With a loan that you’re planning to keep at least two to five years, and perhaps longer if you turn the property into a rental, you should consider other options.

How about this compromise? You could get a 3-year ARM or a 5-year ARM, which would be amortized over 15, 20 or even 30 years. The interest rate would still be quite low, but would be fixed for 3 to 5 years before adjusting. Because the rate could only rise 1 or 2 percent per year, your low rates would be protected for at least 5 years on the 3-year ARM and 7 years if you got a 5-year ARM. (Be aware, some ARMs do not have an annual cap, but do have a lifetime cap of 5 or 6 percent.)

Why? If you start your 3-year ARM at 3 percent, the payment is fixed for 3 years. If the rate can only rise by 2 percent maximum, you’d pay 5 percent in year 4 and 7 percent in year 5 of the loan. That’s still a great rate. The overall rate could only rise to 8 or 9 percent over the life of the loan.

Similarly, if you got a 5-year ARM at 4.25 percent, the rate could only rise as high as 9.25 or 10.25 percent (depending on whether the mortgage has a 5 or 6 percent lifetime cap), but you wouldn’t hit that until year 8 of the loan. In that period of time, you’d have ample opportunity to figure out if you’re staying or going, or keeping the property as an investment.

I like the idea of building up at least some equity. It’s a smart move because even though homes in your neighborhood have been skyrocketing in value, things change and I’d hate to see you wind up with a mortgage for more money than the property is worth.

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