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NOTE: IF YOU WANT THE CRITICAL FACTS ABOUT
INTEREST-ONLY WITHOUT ANY FRILLS, GO TO THE INTEREST-ONLY
TUTORIAL.
August 19, 2002
"In looking to refinance my existing
mortgage, I've found some lenders offering "interest only" loans. One
lender is offering an interest only option for 10 years on all its programs.
Since I plan to be in my current house for no more than 10 years, this seems
attractive. The monthly payment is lower than for a fully amortized loan, and
since the payments are all interest they're 100% deductible. Am I overlooking
something?"
Yes, and I�ll tell you what it is in a
moment.
A mortgage is "interest only" if the
monthly mortgage payment does not include any repayment of principal. The
payment is "interest only." So long as the payment remains interest
only, the loan balance remains unchanged.
For example, if a 30-year fixed-rate loan of
$100,000 at 6.25% is interest only, the payment is .0625/12 times $100,000, or
$520.84. Otherwise, the payment would be $615.72, of which $94.88 is
amortization. $615.72 is the "fully amortizing payment" � the
payment that, if maintained over the term of the loan, will pay it off
completely.
If a loan was interest-only for the full term,
the loan balance would be the same at term as it was at the outset. Back in the
twenties, loans of this type were the norm. Borrowers typically refinanced at
term, which worked fine so long as the house didn�t lose value and the
borrower didn�t lose his job.
But the depression of the thirties caused a
large proportion of these loans to go into foreclosure. Lenders stopped writing
them and have never brought them back. They want loans that eventually amortize.
Hence, the interest only loans of today are
interest only for a specified period, usually 5 to 10 years. At the end of that
period, the payment is raised to the fully amortizing level. In such case, the
new payment will be larger than it would have been if it had been fully
amortizing at the outset.
When I wrote about interest only loans a few
years ago, most borrowers seemed to be viewing them as a way to afford more
house. My conclusion at that time was that interest only mortgages were OK for
that purpose, provided that borrowers were reasonably confident that they would
be able to deal with a payment increase in the future.
As in your case, however, the splurge of
interest in interest only mortgages today seems less related to affordability
issues than to concerns about how best to manage personal finances. It is a
healthy shift in attitude, provided that you are focused on the right objective.
For most, that objective is to accumulate wealth during the working years to
afford a comfortable retirement.
Wealth equals assets less debt. It is built up
over the years, by accumulating assets and paying down debt, including (and
especially) home mortgage debt. When you pay down the balance of your mortgage,
you are increasing your wealth by reducing debt. But so long as you have an
interest only mortgage, you are not increasing your wealth in that way.
Of course, you may be increasing your wealth by
accumulating assets instead. If you have such a plan and you have determined
that it is more effective in building wealth during the interest only period
than paying down mortgage debt, fine. But for most homeowners, paying down
mortgage debt is the most effective way to build wealth, especially in today�s
financial environment.
Suppose you have a 6.25% mortgage and your
financial plan calls for increasing your wealth this month by $100. If you put
it in the bank, you may earn 2-4%, depending on the term. If you put it in bonds
or stock, you may earn more, but you take a risk. If you use it to reduce the
balance of your mortgage, you earn 6.25% with no risk at all.
The tax saving on mortgage interest does not
affect such comparisons because you must pay taxes on interest earnings.
Suppose, for example, you are in the 39.1% tax bracket. Then your 6.25% mortgage
costs only 3.81% after taxes, but a 4% CD yields only 2.44% after taxes. The
investment that is most advantageous before taxes is also most advantageous
after taxes.
With the stock market in the tank and most
short-term interest rates below 2%, mortgage loan repayment is the best
investment available to most home owners. That�s why I�m skeptical about the
recent flurry of interest in interest only mortgages. I�m told that much of
the interest comes from relatively sophisticated borrowers, which is worrisome.
A little sophistication can be a dangerous thing.
Copyright Jack Guttentag 2002
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