By Dave Eshleman
For the past few years, many of our lenders have begun offering loans that allow “interest-only” payments. These loans can mean big reductions in your monthly payment, but they’re not for everyone.
Most loan repayments “amortize”: Part of the payment goes to interest, and the rest to reduce the principal balance so that it’s gone by the end of the 15 or 30-year loan term.
Let’s take a 30-year $600,000 loan at 4% as an example.
Monthly payment: $2,864.49. Of that, $2,000 goes to interest and the remaining $864.49 is applied to principal. With each subsequent payment, the principal portion goes up a tad and the interest portion goes down. When you get toward the end of the term, most of your payment goes to principal.
But with an interest-only loan, it all goes to interest and the principal balance stays the same (unless you voluntarily throw some extra money into the payment). So who would want a loan like that? How do you ever get out of debt?
Here are some examples of people who recently opted for interest-only:
“Sam” is about to retire after 30 years as an engineer. He owes $500,000 on his $2,500,000 home in Saratoga, with a monthly payment of about $3,000. He and his wife would like to travel and enjoy their retirement years. With $2 million in equity and another $2 million in IRA, he doesn’t see any need to continue to chip away at his mortgage balance, and by refinancing into an interest-only loan, he can cut his monthly debt by $1,334 per month. “That pays for a lot of nice meals and guided tours,” Sam remarked.
“Sally” is also retired, living on social security. She just sold a duplex in Santa Cruz and purchased a $1.5 million fourplex in San Jose a part of a 1031 tax-deferred exchange. An interest-only loan will lower her payments by $1,185 per month. Since she relies on positive cash flow to pay her monthly bills, she needs the lowest payments possible. “An extra $1,185 makes a big difference in my life, “ she reported. “I’m not going to live long enough to pay the loan off, so why not enjoy the income while I can?”
“Vince and Judy” are purchasing their first home at $1.2 million. But because home prices are increasing so rapidly, they were forced to go way over their comfort zone in order to have their offer accepted. They’re both tech workers with high income, but amortizing payments will be a shock to their budget and lifestyle. Interest-only payments will drop the required payment by $1,153 per month. “I like that I can make payments to principal if I want, but I’m not forced to,” Judy remarked. “After we get settled in and get the expense of furnishing the home out of the way, we may start paying down the principal. But until then, the lower payments really rock!”
“Raj” is a young engineer who has lived in his home for about five years. He also likes to dabble with stocks and other investments. When he compared how much equity he’s built in his home through appreciation vs. principal reduction, he felt he’d be better off investing the money that would have gone to principal elsewhere. “At 4%, the money’s really only costing me about 2.8% after taxes” he estimated. “If I can’t do better than 2.8% by putting that money in the market, I’m a pretty lousy investor!”
Before taking out an interest-only loan, you must decide on your goals. Is this home a long-term or short-term hold? Get advice from a financial planner. And remember that it’s harder to qualify for an interest-only loan, as banks see them as somewhat riskier than amortizing loans. And of course, call us at (408)872-8100 for details.