- - Thursday, April 12, 2012

Q. We have a $300,000 fixed-rate loan at 5.25 percent with 26 years left on the term. Our home is worth at least $600,000, and we have great credit and income.

We called a local mortgage broker who recommended two refinance programs. We could take out another 30-year fixed-rate loan at a rate of 4.25 percent with no fees, or we could take an interest-only 10/1 adjustable-rate mortgage (ARM) at 3.75 percent with no fees.

I think we should take the 10/1 ARM because we’re certain to sell within 10 years. My wife says interest-only loans are dangerous and thinks they are what got us into the economic mess we’re in.

What do you think?

A. I don’t necessarily think interest-only loans are responsible for the financial crisis of 2008. Perhaps the misuse of this product contributed to the crisis, but the product itself was not the cause. Automobiles don’t cause deaths; accidents and poor driving do.

Interest-only (i/o) loans allow for a monthly payment that includes only the interest charged for the month. No principal payment is made, allowing for a lower monthly payment.

Before the financial crisis, homebuyers were taking out i/o loans to purchase properties they couldn’t intrinsically afford and using the i/o feature to borrow more money with the same payment as an amortized loan.

Even if you make interest-only payments, your situation does not fall into a high-risk scenario for a couple of reasons. First, your loan balance is just 50 percent of your home’s value. Catastrophic events would have to occur for your property to be worth just $300,000 10 years from now.

Second, a high income means a high tax rate. Because mortgage interest is tax deductible, a reasonable rule of thumb is to discount the mortgage rate by 25 percent to account for the mortgage-interest deduction. This means your after-tax interest rate might be closer to 2.75 percent. That’s cheap money no matter how you look at it, so I don’t see any crime in not paying down a $300,000 mortgage under this scenario.

A 10/1 ARM means the rate is fixed for the first 10 years and will adjust annually thereafter. If you and your wife agree the chances are remote that you will still own the house in 10 years, the 10/1 ARM carries no risk because the loan will be paid off before the rate can rise.

I certainly would not recommend against the 10/1 ARM in your situation. The interest savings between 4.25 percent and 3.75 percent over a 10-year period is significant.

The interest-only payment at 3.75 percent is $938 per month. The amortized payment at 4.25 percent is $1,476, a difference of $538. Over 10 years, the cash-flow savings is $64,560. The balance of the loan at the end of 10 years under the amortized program is $238,330, a reduction in principal of $61,670.

This means that even if you stick the $538 difference in the monthly payment under the mattress, where it earns no interest, you will be $2,890 richer under the 10/1 interest-only ARM. If the $538 is invested wisely, the difference could be far greater.

As long as you and your wife are comfortable with the fact that the rate can increase in 10 years, the 10/1 is the way to go. But your loan officer also should have given you fixed-rate options with shorter terms, such as a 20- or a 15-year fixed. Those loans carry lower rates and require higher payments, but you will become debt-free much sooner.

There’s not a “right” or “wrong” program when it comes to mortgage financing. The right program is the one that best matches the objectives of the borrower.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.

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