There Is No Interest Rate Risk

Category: Finance, Mortgages.

A lot of the press today is states that interest only loans are" bad" and that they should be avoided. Once you understand how the typical product works, you can make your own educated decision.

Instead, let s examine why you might want to get an interest only loan. Think of your mortgage as a financial instrument that needs to be managed and integrated with your other financial goals. The repayment period of the loan is traditionally 30 years. A conservative example of an interest only mortgage product allows for ten years of" interest only payments" . The interest rate is fixed during the entire 30 year repayment period. Fannie Mae is a government sponsored entity.

This loan offered through lenders selling to Fannie Mae. They are very large and significant purchaser of loans, so you shouldn t have too much trouble finding this loan. This loan product allows the first ten of the thirty years to have payments based on just repayment of the interest or" interest only" . Most mortgage brokers will be able to offer it to you. After the initial ten year period, the outstanding remaining balance, often the same as it was in the beginning, needs to be amortized and paid off. The interest rate remains the same as the initial rate.

You now have a 20 year loan, which represents the remaining time left on the mortgage. There was NO change in the interest rate. The only variable that changes is the amortization period, having gone from 30 to now 20 years. There is no interest rate risk. If you want interest only payments again, simply refinance. How can an interest only mortgage be a good thing? In fact, there are no prepayment penalties to pay off this loan.

Your mortgage payments are less than a traditional amortizing loan. This means you can get the home you want for a lower payment. The actual payment differential is about$ 100 per 100K borrowed. This allows you to allocate the" savings in payments" into other places. For example, maybe you are not taking advantage of a retirement plan at work or the employer match. One good place might be your retirement plan.

Salary deferred into a retirement plan is generally on a pre- tax basis. Instead these tax deferred dollars are compounding in your retirement plan. This allows you to pick up the differential in dollars that would have been lost to taxes. If you are able to pick up the employer match where you hadn t before, you effectively are earning up to 100% on your deferred dollar, assuming the match is dollar for dollar. This generally translates into 20% more of a home for the same monthly payment. Interest only payments enable you to buy a larger home with the payment you find comfortable. This extra 20% of buying power might allow you to" buy up" to what you really want.

Moving often may strip you of a lot of your potential equity due to the costs involved in buying and selling a home. Getting more of what you need in a home will allow you to remain in that home longer and build more equity. You can t deduct principal. This is what you may be able to deduct on your taxes. At the end of the year, your lender will send you a 109This form represents the amount of interest that you ve paid in the previous year. Principal repayment is never deductible and may actually accelerate the loss of your" tax deduction i. e. mortgage interest" by reducing the outstanding mortgage balance from which interest is calculated. This is mortgage interest rate arbitrage.

You may be able to earn a higher rate on your invested funds than the rate you are able to borrow money at for a mortgage. This is why you might want to borrow as large a mortgage as you feel comfortable maintaining and invest your equity somewhere else. Last time I looked, it worked pretty well for them. Following this strategy, you are doing the same things that banks and insurance companies participate in. Your equity due to appreciation grows the same way regardless of how you finance a home. Consider this: if you can buy more of a home with an interest only loan, and if all homes appreciate by the same percentage, then you will gain more equity from the home that initially costs more. Equity growth is based on the appreciation of the underlying property.

The equity that you are building through amortization by paying down on a mortgage is really just a" forced" savings plan. If you should want your home paid off or paid down in the future, simply liquidate this alternative investment and apply it to your outstanding mortgage balance. It may be possible to take these payment savings that you pay into the" forced" savings plan and instead invest them into some alternative investment that will appreciate at a higher rate. What are the negatives? For example, you could argue that there are no alternative investments that offer a higher rate than the net rate you re paying on your mortgage based on the risk you are willing to take. You might be able to argue the other side of the advantages I ve outlined, but I think you would be remiss. This might be the case for the most conservative.

To be objective there might be one risk to consider. If that s the case, I still think the other advantages provide enough reasons to consider an interest only loan. If you don t think you can make the mortgage payment after the interest only period and you feel that in the future you might not be able to refinance or sell your home, then you should, for whatever reason stick with a traditional 30 year fixed conventional loan.

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