Interest-Only Loans Can Cut Payments
By Paul Katzeff, Investor's Business Daily
March 8, 2004

Invest The Difference - But the risk is greater payments may be higher further down the road. How would you like to cut your mortgage interest rate nearly in half? And what if you could cut your monthly payment by more than half?

You can do that, but it makes sense only under certain conditions. The loan that lets you do those things is an interest-only (IO) mortgage. It is a type of adjustable-rate mortgage. Instead of writing a check each month for interest and principal, with an IO ARM you pay only interest for an agreed period of time. The interest-only period often ranges up to 10 years. But three years of interest-only payments is the most common format, says David Herpers, director of consumer affairs for Amerisave Mortgage, an online lender.



Pre-Set Changes

"In the 3-1 format, the interest rate is set for three years, then it adjusts once a year," Herpers said. The amount your rate can rise or fall yearly is specified at the outset. So is the lifetime cap on rate adjustment.

Rates are adjusted the same as with traditional ARMs. They float at a certain level above an index, such as the T-bill rate. They're reset at regular intervals, often once a year.

The downside: by delaying repayment of principal, you'll be hit with larger monthly bills in later years.

One benefit to an IO ARM is that a lower monthly payment lets you invest the savings.

"You 'save' the principal that you'd otherwise pay each month in a conventional loan," said Martin Nissenbaum, national director of personal income tax planning for Ernst & Young. "You're betting that you can earn more by investing that principal than you pay out in interest over the entire life of the loan."

Still, another benefit is that you can pocket the savings or use it to pay off other, higher-cost debt. That lower monthly nut also comes in handy if you've lost your job. That's one reason IO ARMs grew in popularity in recent years, which were scarred by a recession. For example, Fannie Mae, the giant buyer of home loans from mortgage lenders, also began to underwrite IO ARMs about three years ago. You can also use the savings to pay down your principal.

"That's a strategy with built-in flexibility," Herpers said. "If you need the money for something else, you don't have to pay any principal." Generally, there's no penalty for paying principal voluntarily. An IO ARM can also help you qualify for a larger mortgage with some lenders.

"Borrowers get approved for a particular size monthly payment, not a loan amount," Herpers said. "You qualify based on the ratio of payment to your monthly income." But most lenders won't let you use that strategy, Herpers says. That's because they know an IO ARM often requires bigger monthly payments in later phases.



Drawbacks

That's part of the downside to an IO ARM. With this type of loan, you do not cut the balance you owe during the initial interest-only phase. And you don't build your equity by cutting the outstanding balance.

Another risk: Interest rates could rise a lot over the life of the loan.

Together, that means your combined interest and principal payments, after the initial interest-only period, can rise a lot. If you have a 30-year IO ARM that doesn't require principal payments for the first 10 years, then starting in year 11 you'd be faced with paying off a 30-year loan in just 20 years. "Plus, you'd also risk getting hit with higher interest rates," Herpers said. "I would not advise anyone to take this product if he plans to stay in his house for 30 years." An IO ARM works best if you plan to get rid of the loan within a short period. "One scenario is if you plan to sell the home," Herpers said.

Look what happens if you invest your monthly savings. Say you have a $200,000 home loan. A 30-year fixed-rate loan might cost you 5.5%. A comparable one-year IO ARM could cost 3% now, Herpers says. And let's say you're in the 28% tax bracket. Your monthly payment with the fixed-rate loan would be $1,136. It'd start at only $500 with a 3-1 IO ARM. Suppose you can earn 8% a year on your investments. After three years your investments would be worth $22,279.

Since you can write off mortgage interest, your cumulative tax savings with a regular loan would be $9,053 after three years. At the IO ARM's lower rate, it'd be $5,930. But say your IO ARM interest rate rises 0.25% a year. After three years, your rate would be 3.92%. So your net gain by the end of year three, despite a higher principal balance: $10,609. After 10 years, it could be $37,623. "If rates don't rise too much, an IO works," Herpers said. "But if rates rise a lot, in the long run it could more than wipe out any net gain in early years."

Amerisave is one of the nation's leading and fastest-growing online mortgage companies, serving customers in all 50 states and DC via its Web site, www.amerisave.com. Amerisave's mission is to provide the best rates from top banks for a variety of home financing needs. The company provides customers the ability to obtain the most competitive rates instantly via the Web. Amerisave offers a $300 guarantee that consumers will not find a mortgage loan at lower cost in rates and fees.