Q. I have an interest-only loan at 4.75 percent with balance of $288,000. It’s a 30-year fixed rate with an interest-only payment period for the first 10 years.
I am six years away from being required to start paying down principal. This future payment shock is beginning to worry me. Even though my rate is good, I’m thinking of refinancing to a new 30-year fixed-rate loan that has a regular amortization.
I’m regretting my decision to go with an interest-only loan. Would you advise that I play it safe and refinance?
A. Absolutely not. I speak with homeowners about this issue all the time. It seems a lot of folks have a fundamental misunderstanding of an interest-only loan.
Instead of referring to interest-only loans as “interest only,” I prefer to call them “loans with an interest-only payment option.” In other words, you are not required to make interest-only payments during the first 10 years of the term, but you may, if you choose. You can make principal payments during this period anytime you wish.
Having said that, let’s crunch the numbers. At 4.75 percent, your interest-only payment should be about $1,140 per month (.0475 x $288,000/12 months). Because you are four years into a 30-year loan, you would need to start paying down this loan over a 26-year period. My calculator tells me a $288,000 loan amortized over 26 years at 4.75 percent would require a principal-and-interest payment of $1,609 per month.
Beginning with next month’s payment, include an extra $469 with the interest payment.
If you continue to make interest-only payments for the next six years, the payment shock will be much more severe. You will have to begin paying down a $288,000 balance over a 20-year period. This will require a principal-and-interest payment of $1,861 - an increase of $721 from your existing interest payment.
A mortgage program with an interest-only payment option is not necessarily the evil mortgage plan often described in the media. It simply gives the consumer choice, and like anything else, must be chosen wisely.
For example, I have an interest-only payment option on my loan. The rate is 3.75 percent, and the balance is only about 50 percent of the property’s value. I have no plans to sell in the next 10 or 20 years. Because the interest rate and loan-to-value are so low, coupled with no urgency to sell, the interest-only payments are just fine.
Let’s compare that situation with that of someone who is buying a home in hopes of selling in a year or two with a big profit. He takes an interest-only loan and puts zero money down. We all now know that property values don’t always rise. If this fellow’s purchase is ill-timed, he may be underwater on the loan in two years, and making interest-only payments certainly won’t help the situation.
Henry Savage is president of PMC Mortgage in Alexandria, Va. Send e-mail to henrysavage@pmcmortgage.com.
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