Are Interest-Only Mortgages Right for You? You Might Be Surprised.

Interest-only rate mortgages might be especially tempting if you are struggling with cash flow or if you only plan on staying in your home for a short time before selling it.  But if you plan on staying in your home for a long period of time, they are risky – and a gamble I usually refrain from.

Let’s look at an example. A friend of mine has an outstanding balance of over $700,000 on his mortgage. He wanted to know if he should refinance his mortgage and get a fixed 30-year loan.  Let’s take a look.

He currently has a five-year interest-only loan and makes a monthly payment of $2,400. He told me that he can refinance now and get a fixed 30-year mortgage. If he does so, his payments will go up to $3,600 a month. That’s a steep increase I admit and one he’s not happy about.

But he told me that he lives in his dream house and hopes to stay in his current home forever. He was thinking of holding on to his current interest-only loan, keep his expenses low and then refinance in five years. His plan is to keep his expenses low for as long as possible and live off of his retirement investments in about 10 years.

Over the past decade, this strategy has worked well because interest rates have declined steadily over that period.  But rates are in the cellar now and they can’t get much lower.  They might stay low for a long time but nobody knows for sure. And what if they don’t?

If you are building your retirement plan based on spending a fixed amount on housing, doesn’t it makes sense to have a fixed rate?  Yes, coming up with an extra $1200 will be painful each month for my buddy. But it will hurt less than having to leave his dream home if rates go up significantly over the next 5 years.

I don’t know what will happen to interest rates in the future but let’s assume they do rise.  If we assume that my friend will have to refi when rates are 7%, his monthly payment could be as high as $4657.  He won’t be able to afford that or come up with the cash to pay off the balloon payment.  So if rates do rise dramatically, my friend will have to leave his home.  Bottom line?  My friend can either lock in a payment of $3,600 a month now or take his chances on what the rate will be in five years.  How needs to take that kind of risk?

What About If The Only Way You Can Afford A Place Is To Use An Interest Only Loan?

If the only way you can make your payments is to buy a house using an interest only mortgage, I beg you to look for a less expensive place to hang your hat.  Again, if rates rise in the future you might be setting yourself up for a very ugly experience down the road.

What are you going to do if you find yourself in the position my friend may be in 5 years from now?  He’s looking at the real possibility of leaving his home or having to come up with an extra $2,000 a month should rates rise to 7%.  And you could be in that same boat.  If so, where is that extra money going to come from?   And if interest rates go up when real estate prices are dropping, you may really get roughed up.  You will either have to come up with a lot more cabbage each month to keep the house or lose the house and the money you put into the down payment too.  Yuk.

When I comes to real estate, the best policy is to think and act conservatively.  Consider the worst case and make sure you can weather that storm.  Because interest-only loans expose you to so much risk, I say, forget it.  Interest-only mortgages might be good if you know you are only going to stay in the house for the duration of the fixed rate (or maybe a little longer). But if that’s the case, you might re-consider your decision to buy property in the first place.  You might be taking too much risk as it is.

Have you thought about using an interest-only mortgage?  Why or why not?

photo. All-Seeing angler