There is a reason loan officers have many
different loan programs available to offer their clients.
Although the traditional 30 year fixed mortgage is probably
the most common program, many alternatives are becoming quite
common place within the mortgage industry. Almost half of
my clients choose a different loan program other than the
30 year fixed program because an alternative program benefits
their current and future financial goals. The most common
of these alternative programs is the interest only loan. After
reading this article, you the prospective borrower, will be
able to decide if interest only is something you should consider
when acquiring your next mortgage.
Most
consumers, rightfully so, are immediately alarmed when they
hear the term “interest only” mentioned in regards to their
mortgage. The word “only” creates a feeling like we are being
forced into something. However, the interest only loan should
more accurately be labeled the “interest only option” loan.
That’s right, you are not forced to pay interest only on your
mortgage, it is simply an option you have when deciding how
much to pay each month towards your mortgage. For a lot of
my clients, and probably some of you reading this article,
it might be to your advantage to decide how much each month
you want to pay towards your principal. (Your mortgage payment
consists of two parts, the principal and the interest. For
example: A 30 year fixed mortgage at 5.75% on $200,000 has
a payment of $1,167.15, $958.33 going towards interest and
$208.82 towards principal reduction.)
Many
people tend to have flexible budgets from month to month.
Whether you are self-employed and your income varies each
month, or your family accumulates more expenses during certain
times of the year, the interest only option may give you the
flexibility you need. Imagine having the option to pay $300
dollars less on your mortgage during the months you need the
extra cash. Sound appealing? For those great months, where
money is abundant, you can choose to pay a little more towards
principal to balance out the months where you made an interest
only payment. The interest only loan allows you to make the
decision each month as to what will work best for you and
your family’s finances.
Example
of the interest only option payment compared to a principal
and interest payment:
$200,000
loan amount
| 5
Year Arm 5.125% |
30
Year Fixed 5.75% |
| Interest
Only Option |
Principal
and Interest |
| $854.17
|
$1,167.15 |
| Minimum
Monthly Payment |
Monthly
Payment |
Savings
per Month of $312.98
Looking
at the example above, it is obvious why some may choose the
interest only option. For many, saving over $300 a month can
make a big difference for their monthly budget. But are you
really saving that $300? Not really, most of the savings is
simply the money you would be paying towards your principal.
Let me clarify, when someone chooses to make an interest only
payment, the balance of their mortgage stays the same. If
you continue to make interest only payments throughout the
next several years you will still owe the same amount you
originally borrowed. Well, why would someone want to do that?
Isn’t the whole point of having a mortgage to pay it off?
Not necessarily!
The
most common reason my clients choose the interest only option
is because it is simply more affordable. Home prices have
risen quite dramatically in the Chico area, and for a lot
of buyers, the only way to afford purchasing a home is by
choosing the interest only option (interest only is available
for refinances as well as purchases). Although these buyers
may not be paying off their mortgage, they are still making
an excellent investment. None of us would buy a home if we
didn’t think it was a smart investment. The only way buying
a home becomes a wise investment is if the value of the home
increases while you own it, creating more equity. Sure, if
you pay down your principal on your mortgage you do create
more equity. However, that equity was not free, for each dollar
you pay towards principal you receive one dollar of equity
in return. The equity we all want to get is the free kind,
owning the home and watching the value soar, even if we still
owe the original amount borrowed.
Paying
down the principal is not even a consideration for some borrowers.
I have clients who know that at some point in the future they
will be selling or upgrading their home. They make a conscious
decision to pay interest only on their mortgage while investing
the extra money they would normally be paying towards principal.
For example: Sam and Judy decide to pay just the interest
on their home loan and put the extra $450 a month into their
401k retirement account. Is this a smart choice? Considering
that Sam’s 401k has been earning him 10% on his money over
the last five years, it seems to be a very smart move. If
you could borrow money at 6% and turn around and make 10%
on it (a net gain of 4%), wouldn’t you jump at the opportunity?
This is thinking outside the box for some, but I hope this
idea makes some of you investigate a little deeper when making
your next mortgage decision. I have clients that take 2nd
mortgages out on their homes at 6.5% to solely put that money
into their other in vestments that give them a greater rate
of return (not to mention the added tax benefits of interest
paid on your principal residence). Some clients are willing
to take calculated risks in order to gain large returns on
their money. This is not something I recommend for the ultra
conservative who will end up loosing sleep at night wondering
if they made the right decision.
You
now have the basic knowledge required to make an educated
choice regarding the interest only option mortgage. It’s not
for everyone, but I bet quite a few of you will find that
an interest only loan may be the right loan program for your
financial position. Give it some careful consideration, but
most importantly, make a decision with your loan officer that
you feel comfortable with. Next months article will discuss
2nd mortgages, how they can be used to your advantage and
the many different types available to the borrower.
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