To Pay or Not To Pay

Do interest only loans make sense?

It's no surprise that interest-only mortgages have gained in popularity. For home buyers, interest-only loans increase affordability -- something that many homebuyers need after the last few years of skyrocketing home prices.

But interest-only loans are not just popular among buyers. Many existing homeowners are turning in their traditional amortizing loan for a lower-payment, interest-only loan.

When you think about what has happened in the marketplace in the last few years, it's no surprise. Interest rates are at record lows, and homeowners are enjoying new found wealth with the surge in home values. With this kind of combination, why would a homeowner bother to chip away at the loan balance?

The answer is easy: Indeed, he may not want to pay down principal for those exact reasons. It all depends on the situation. Here's a real-life example:

I know a woman who refinanced her $400,000 loan to an interest-only LIBOR ARM with a current rate of four percent. The monthly interest payment is only $1,333. Under this payment plan, her mortgage balance does not decrease.

By contrast, she could have refinanced to a jumbo fixed-rate amortized over 30 years to a rate of about six percent. Her monthly P&I payment would have been $2,398 -- an increase of $1,065. Under this scenario, her balance will be decrease, albeit slowly.

So the woman refis to the LIBOR ARM and each month she takes her $1,065 "savings" and sticks it in a reliable mutual fund. Her logic is simple. She thinks she can build her mutual fund account at a quicker pace than she would have been able to curtail her principal by taking the higher rate, amortized loan.

Unless the LIBOR skyrockets, she's completely right. At the end of five years, assuming the LIBOR holds steady, she would have deposited a total of $63,900 in the mutual fund account. If she had chosen the six percent amortized loan, her mortgage balance would have dropped to $372,217 -- only by $27,783. She'd be $36,117 ahead if everything remained static.

Of course, it gets much more complicated because things don't remain static. First, her LIBOR rate is likely to increase. By how much nobody knows, and it could rise and then fall again. Also, there's a small additional tax savings by taking the higher rate, because she would be paying more tax-deductible interest. Finally, the $63,900 does not take into consideration any appreciation in value of the mutual fund shares, which is very likely.

Here' the bottom line: She must be able to earn a higher return by investing the money she is borrowing. Every dollar that doesn't go towards paying off the mortgage loan is borrowed money. Her current rate is four percent. Let's take 25 percent off the four percent for her mortgage interest tax deduction and her actual "cost-to-borrow" is only 3.20 percent. As long as her mutual fund performs better than this number, she'll be ahead.

The downside is obvious. If her adjustable rate LIBOR spikes, her "cost-to-borrow" gets more expensive. The mutual fund will have to increase its performance to keep up with the rising interest rate. If her rate rises and the mutual fund tanks, she'll be losing money. She'd better start paying off the loan.

Remember that the other side of the coin works, too. Taking out a 30-year, fixed-rate mortgage will eventually retire the debt -- no fuss no muss, no risk.