Q.
Be, I’m thinking about refinancing my home and taking out an interest only (IO) loan. What do you think? What do I need to know before going in? -K
A.
K, I have a couple answers for you on this question:
- Knee Jerk Reaction: In general I don’t like the idea of interest only on your own residence. Many savvy investors go the interest only route in order to preserve cash flow on rentals. In the case of your own residence YOU are the renter so the cash flow question is really one of affordability. Can you afford this house or are you over leveraging?
- On the other hand: If you are VERY knowledgeable about the terms of the loan, and this type of loan is a tool in a larger strategy I can understand the thought. Perhaps you can find a loan that is fixed rate interest only and you plan on converting this home to a rental in the near future. The problems occur typically when homeowners take on IO loans that have low introductory rates but are not aware of the effect of a rate shift on their monthly payments. For example, a $300,000 interest only payment at 3.9% would be roughly $975/month (no taxes or insurance included). When that rate adjusts, say to 5.9% the payment jumps by more than 50% to $1475/month.
It is important to know your loan product and get the right advice. On that note I have asked my trusted loan professional to field this question as well. Here is his answer:
Bryndan,
Someone offered me $15,000 for my Dad’s car, should he take it? The answer is as simple/complex as your question. I know what my Dad drives so the answer is easy, but you don’t know if he drives a 2007 CLS55 Mercedes or a 1982 Toyota Tercel with 287000 miles.
For me, I/O loans make sense; I do not receive income on a smooth annual basis. My money comes in waves, the beginning of the year representing 20% the middle 50% and the end of the year 30% with bonus amounts of cash thrown in throughout the year. For this reason I can keep my monthly payment low, while affording me the opportunity to quickly reduce my balance (as well as my monthly payment) at any time. This principal reduction is made whenever I send in extra money. I would not; however, suggest this planning if you are a W2 employee who makes $XXXX per month, every month with no bonus or overtime opportunities.
For me, I/O loans make sense; I do not receive income on a smooth annual basis. My money comes in waves, the beginning of the year representing 20% the middle 50% and the end of the year 30% with bonus amounts of cash thrown in throughout the year. For this reason I can keep my monthly payment low, while affording me the opportunity to quickly reduce my balance (as well as my monthly payment) at any time. This principal reduction is made whenever I send in extra money. I would not; however, suggest this planning if you are a W2 employee who makes $XXXX per month, every month with no bonus or overtime opportunities.
I/O can also be a strategy to get into a larger home that is an area recognizing a better than average appreciation.
Again, the answer can be complex and this is why I always recommend that you consult a trained mortgage professional before just applying at the local bank or over the internet for a loan you do not understand.
-Bob Baerenbach
Thanks for the question ‘K’.
-Bryndan
