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Interest-Only Loans Not Ideal

September 15, 2002|JACK GUTTENTAG | SPECIAL TO THE TIMES

Question: In looking to refinance my existing mortgage, I've found some lenders offering interest-only loans. One lender is offering an interest-only option for 10 years. Because I plan to be in my current house for no more than 10 years, this seems attractive. The monthly payment is lower than that for a fully amortized loan, and because the payments are all interest they're 100% tax-deductible. Am I overlooking something?

Answer: Yes. A mortgage is interest only if the monthly payment does not include any repayment of principal. So long as the payment remains interest only, the loan balance remains unchanged.

If a 30-year fixed-rate loan of $100,000 at 6.25% is interest only, the payment is $520.84. Otherwise the payment would be $615.72, of which $94.88 is amortization. This $615.72, the "fully amortizing payment," is the payment that, if maintained over the term of the loan, will pay it off completely. If a loan were interest only for the full term, the balance would be the same at term as it was at the outset.

In the 1920s, loans of this type were the norm; borrowers typically refinanced at term. But the Depression of the '30s caused many to go into foreclosure, and lenders stopped writing the loans.

Hence the interest-only loans of today are interest only for a specified period, usually five to 10 years. At the end of that period, the payment is raised to the fully amortizing level. In such cases the new payment will be larger than it would have been if it had been fully amortizing at the outset.

The surge of interest in interest-only mortgages today seems to be related to concerns about how best to manage personal finances. It is a healthy shift in attitude, provided that you are focused on the right objective. For most, that objective is to accumulate wealth during the working years to afford a comfortable retirement.

Wealth equals assets less debt. It is built up over the years by accumulating assets and paying down debt, especially mortgage debt. When you pay down the balance of your mortgage, you are increasing your wealth by reducing debt. But an interest-only mortgage does not increase wealth in that way.

Of course, you may be increasing your wealth by accumulating assets instead. If you have such a plan and you have determined that it is more effective in building wealth during the interest-only period than paying down mortgage debt, fine. Paying down mortgage debt is the most effective way to build wealth, especially in today's financial environment.

Suppose you have a 6.25% mortgage and your financial plan calls for increasing your wealth this month by $100. If you put it in the bank, you may earn 2% to 4%. If you put it in bonds or stock, you may earn more but you take a risk. If you use it to reduce the balance of your mortgage, you earn 6.25% with no risk at all.

The tax saving on mortgage interest does not affect such comparisons because you must pay taxes on interest earnings. Suppose you are in the 39.1% tax bracket. Then your 6.25% mortgage costs only 3.81% after taxes, but a 4% CD yields only 2.44% after taxes. The investment that is most advantageous before taxes is also most advantageous after taxes.

With the stock market in the tank and most short-term interest rates below 2%, mortgage loan repayment is the best investment available to most homeowners.

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Jack Guttentag is a syndicated columnist and professor of finance emeritus at the Wharton School of the University of Pennsylvania. Questions or comments can be left at www.mtgprofessor.com. Distributed by Inman News Features.

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