A new trend in home-buying is emerging…the interest-only (i/o) loan. Although interest-only loans have been available for quite some time, they’re becoming more popular. Currently about half of all adjustable-rate mortgages are interest-only, according to E-Loan. But why in the world would you want to get an interest-only loan? Isn’t the point of home-ownership building equity and security? That’s one of the points, but an interest-only loan can be a viable alternative if you meet several criteria. For instance, you need a credit score of at least 680 if you’re a salaried borrower, and if you’re self-employed you need a 700 or higher. But we’re getting ahead of ourselves.
To put i/o loans in historical perspective, interest-only loans were popular in the 1920s when home buyers wanted to free up cash to invest in the stock market. When the 1929 crash came, scores of foreclosures bankrupted the i/o homebuyers. Just something to keep in mind as we explore this option.
First, the good news: i/o loans increase house affordability by 20 percent. If you qualify for a $250,000 loan, you now can get $300,000; $300,000 becomes $360,000; and $400,000 becomes $480,000. In other words, you can qualify for a more expensive home than you would with a traditional mortgage. And the payments are dramatically different. On a five-year interest-only loan at 3.875%, your payment is $1,615. On a five-year hybrid at 3.750%, your payment jumps to $2,316. And on a 30-year fixed at 5.750%, your payment $2,918. Quite a difference there.
How interest-only loans work:
Interest only loans do not prohibit you from paying down the principal balance. Most are available only with adjustable rate mortgages. Most are five, seven or ten year interest-only periods, where the rate is fixed. After the initial period, the rate can rise up to six percentage points. For instance, a 5/1 ARM rate is fixed for five years and the i/o may only be for five years, and the next 25 would be traditional principal plus interest—greatly increasing your payment. After the initial interest-only period, the loan becomes a fully amortized 30-year mortgage loan with no pre-payment penalty.
Now for the (potentially) bad news. The payment differences break down as follows over the life of a five-year interest-only ARM:
Years one through five at 3.875%, your payment is $1,615. Years six through eight at 6.875%, your payment is $2,864. Years eight through ten at 9.875%, your payment is $4,114. Years 10 through 30 at 9.875%, your payment is $4,783. This last jump is due to the fact that during the last 20 years of the loan, the principal is spread out over 20 years as opposed to the traditional 30.
You may want an i/o if:
- You’re disciplined with money
- You’re something of a risk taker
- You’re not taking on more than you can handle comfortably
- You expect your income to rise sharply in the next five years
- You have an irregular income (like commissioned sales) so that the lower payment is manageable during lean periods and when the money is coming in can pay down the principal
- You’re content to let rising markets build your equity for you
- Home prices continue to rise
You don’t if:
- You have a lot of consumer debt that you can’t get a handle on
- You plan on being in your house longer than the interest-only period
- You’re undisciplined with your finances
- You’re borrowing a small amount (the savings might not offset the loan’s greater risk)
- You plan on spending the extra cash on “discretionary” items (your overall net worth will suffer)
- You plan to sell or refinance before the interest-only period ends
- You want to lock in today’s low interest rates