Primary marketInterest Only Loans Ease Monthly Obligations
Question: I read your LIBORMANIA column with great interest. What especially intrigued me is the interest only feature on a mortgage program with such a low rate. I have a similar situation in that I have a 5/1 Adjustable Rate with a balance of $300,000 at six percent. My current principal and interest (P&I) payment is $1,799. Is it true that if I refinanced to a LIBOR ARM at 3.50 percent my interest only payment would only be $875? It seems unbelievable. I"ve got three kids and a very small college fund. This program would allow me to save an additional $924 per month. Do you think this is a wise decision? Also, everybody keeps saying that the stock market will eventually go up again and now is the time to start investing. I would like your thoughts on this. Thanks.
Answer: Let"s dissect your situation and analyze it:
Your current mortgage rate is six percent. Depending upon how old your loan is, the rate will adjust sometime in the next five years. In other words, you will be subject to market rates - whatever they may be.
Your current loan is amortized over thirty years. This means a portion of your $1,799 payment pays off the loan balance. This is always a good thing because it lowers your debt level.
There are two reasons why the difference between the LIBOR payment and your current payment seems "unbelievable." First, the interest rate is a lot lower on the LIBOR ARM. The "cost to borrow" is only 3.50 percent per year - as compared to six percent on your current loan. Second, an interest only payment is just that - not a dime gets plowed into principal so your loan balance never changes.
You appear to have some ideas that suggest a preferred use of your money than paying down your mortgage, such as investing in the equities markets or saving for college.
An interest only mortgage might very well be right for you but you need to know the upside and downside.
There are various interest only adjustable rate mortgages (ARMs) available. Some carry an initial fixed rate for three or five years so you"re protected for a while against rising rates. Note that the 3.50 percent LIBOR in my previous column is a monthly ARM. An interest only ARM that"s fixed for five years will carry a much higher rates that 3.50 percent.
If your current six percent loan carried an interest only payment feature, the payment would be $1,500 per month - only $299 less than a fully amortized payment. So if you"re looking for significant cash relief, a low interest rate is necessary.
What I"m getting at is this: A lower interest rate on an ARM means higher risk to you. The rate on the LIBOR ARM that I like so much can change every month so anyone that takes this loan is completely subject to interest rate volatility. But it"s a cheap rate.
Now let"s talk about your $924 monthly decrease in mortgage payment. Indeed, if you are serious about establishing a decent college fund, a $924 deposited monthly and invested wisely is surely to grow over the long haul. But remember that it won"t be $924 forever. The LIBOR will go up eventually, and when it does, that $924 spread will shrink.
As for the stock market, who knows? Deciding when to invest in stocks is a personal decision. The only rule that I know is to buy low and sell high. The problem is that nobody knows when the "low" and "high" are.
Since your loan is subject to market rates sometime in the next five years, I certainly wouldn"t tell you that a 3.50 percent LIBOR isn"t right for you. Since the LIBOR is currently so low, it could take years before the rate reaches back up to six percent. And in the meantime, you"re building a decent college fund. There are some who would advise against an interest only mortgage because there"s no principal curtailment. That"s a good point and it"s important to pay off a mortgage. But I see too often folks taking out a 30 year or 15 year mortgage who anxiously pay down their loan, only to jack up their mortgage debt a few years later by taking out a home equity line. Seems to me like digging a hole and filling it back up.
If your goal is to keep a mortgage payment low and do something wise with the cash flow relief, a 3.50 percent ARM is a good alternative.