Do Interest-Only Loan Pique Your Interest?

Home ownership has many benefits, but figuring out financing can be tricky. Many people are turning to interest only loans, touted as a way to buy more house for less monthly outlay. Interest only loans come in many variations, but in general you pay a fixed rate of interest but no principal for the first five years, and then the loan becomes a fully amortized adjustable rate loan for the next 25 years.

Let’s do the math. If you have a $250,000 conventional 30-year loan at 6.6%, your payment would be about $1,600 a month.  Can’t afford that much? No problem. An interest only loan at 6% at would cost just $1,250 a month. By paying interest at a lower rate and no principal, you save $350 a month, which is $21,000 over five years.

What’s the catch? Once the five years is up, you’ll be in for some payment shock. If interest rates climb to 7.5%, with principal payments you’ll be paying $1,850 a month, an increase of almost 50%. Ouch!

Don’t worry, you can just refinance, say some. But you’ll have to pay the points and closing costs all over again, which is expensive. And with the volatility in today’s real estate market, what if a housing slump makes your home worth less than your mortgage?  What if you lose your job? You might not be able to refinance at all, and you might be forced to sell your home.

Despite these drawbacks, interest only loans could be the way to go. If you plan to sell the home before the five years is up, the drawbacks aren’t likely to affect you. Interest only loans are attractive if your income, though low now, is increasing, so you’ll be able to afford the payment when the loan converts to a conventional loan. If your annual income is adequate, but comes in spurts from periodic commissions or bonuses, interest-only financing will help you keep the monthly payment low, and you can make supplemental principal payments when your finances allow.

You might find interest-only financing desirable because skipping the principal payment allows you to divert more money into retirement plans, stock portfolios or education funds for children.

The number of single women buying homes has skyrocketed in recent years. Twenty percent of all first time homebuyers are single women, and today single women buy homes at twice the rate of single men, according to the National Association of Realtors. Whether you are married or single, the bottom line on interest only loans is to make sure you can afford the higher payments in the future, and if possible, invest the money that otherwise would have gone into principal.

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