Just paying interest has pros, cons

Q:I am a first-time buyer and am wondering if I’d be hurting myself by taking out an

interest-only loan. Here’s the plan: Buy a town house in the $350,000 range, put down 20 percent and sell within seven years. How harmful would it be if I took out an interest-only loan?

A: The subject of interest-only loans never seems to go away, but I am more than happy to address it again.

First, allow me to outline the facts of interest-only loans.

m A mortgage that allows interest-only payments means that the minimum payment covers the interest charged. Making interest-only payments means the principal balance doesn’t change.

m An interest-only loan doesn’t require that the borrower make interest-only payments. It is simply an option. The borrower may amortize the loan over a specified period by making principal payments if he chooses to do so.

• The time period in which the borrower may make interest-only payments is limited. Depending upon the program, the interest-only payment period is usually limited to the first three, five, seven, or 10 years. The loans are usually 30-year terms, so the loan is amortized over the remaining period after the initial interest-only period.

• Although 30-year, fixed-rate, interest-only loans are available, most folks in recent years have taken out adjustable rate mortgages (ARMs) with an interest-only payment feature. The interest-only payment term usually ceases at the same time that the ARM adjusts. This can exacerbate “payment shock,” because a borrower can suddenly go from paying only the interest on a low rate to an amortized payment on a higher interest rate.

Now let me answer your question as to whether you would be hurting yourself by taking out an interest-only loan.

It depends.

A 20 percent down payment on $350,000 will result in a mortgage loan of $280,000. Using a rate of 6 percent, an interest-only payment would be $1,400 per month. If the loan were amortized over 30 years, the principal and interest payment would be $1,679, a difference of $279.

At the end of seven years, your mortgage balance would remain at $280,000 if you chose to make interest-only payments. If you chose to make the 30-year amortized payment, your mortgage balance would have dropped to about $251,000.

Which is better, gaining $29,000 in equity or saving $279 per month over a seven-year period? Without taking into consideration investment potential, the dollar amount saved with the interest-only program equals $23,436. If you simply stick the $279 savings under a mattress, it’s pretty clear that the amortized loan is a better deal to the tune of $5,564 ($29,000 - $23,436).

But what if you invested the money wisely? A good rule of thumb is to determine if you can earn a compounded return on the $279 at a rate that’s equal or better than the after-tax cost of the mortgage. The mortgage rate is 6 percent. Discount the rate by 25 percent because mortgage interest is tax deductible. The after-tax rate is then 4.50 percent.

Can you invest $279 a month and reap a compounded annual return of 4.50 percent over the next seven years? That will determine whether you will hurt yourself by taking out an interest-only loan.

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