- The Washington Times - Thursday, September 23, 2004

Q: Can interest-only loans be used to pay off a mortgage faster than a traditional 30-year

fixed-rate amortized loan? I would like to pay off my house in seven years. Would an interest-only loan help me? My balance is \$317,000, and I currently have a 30-year fixed-rate loan at 5.875 percent.

A: An interest-only loan allows the borrower to pay only the interest that’s charged on the loan for that month. Making an interest only payment means just that no principal balance is being reduced.

You are asking whether making principal payments every month would result in a quicker payoff than if you made the same payments on an amortized loan.

Unfortunately, the loans would be paid off at the same time, as long as the payment and interest rate stays the same.

I fiddled around with a spreadsheet to illustrate the concept.

Let’s start with your 30-year fixed-rate loan of \$317,000 at 5.875 percent. I don’t know how far along into the loan you are, and this would make a difference, but the concept is the same. I will assume a new loan.

The principal-and-interest payment amortized over 30 years is \$1,875 per month. In order to pay off the loan in seven years, you would need to make an additional \$2,737 payment each month, creating a total payment of \$4,612.

Essentially, you are turning a 30-year fixed-rate loan into a seven-year fixed-rate loan. The most common fixed-rate loans come with either a 30- or a 15-year amortization. As time goes by, the principal portion of the payment increases and the interest portion decreases.

As long as there’s no prepayment penalty, a borrower can make extra principal payments to pay off the loan earlier.

This will indeed save a considerable amount of interest cost.

Let me get back to your question. An interest-only mortgage merely allows an option of paying just the interest charged.

But if you decide, for example, to pay an extra \$2,000 over the interest one month, the next month your balance will be \$315,000 and the minimum required payment would be only the interest on \$315,000.

Another \$2,000 infusion toward principal would reduce the balance to \$313,000, further reducing the interest charge.

This is how an amortization works.

If you make a fixed payment that exceeds the interest charged, the principal will drop every month, allowing more of your fixed payment to curtail principal.

So in a nutshell, a mortgage with an interest-only option will not pay off a loan quicker than an amortized loan.

However, I do have a suggestion. As I said earlier, a lower interest rate will allow either a lower payment or a quicker payoff (because the interest cost is less).

If you are comfortable with a payment of \$4,612, you should consider refinancing to a 15-year fixed rate.

As of this writing, I see that there are 15-year loans at 5.50 percent with no points or closing costs.

Since the interest rate is lower, the payment required to retire the loan in seven years would drop to \$4,555 — \$57 less.

If you change your mind, you always have the option of paying over 15 years.

At any rate, dropping your rate by 0.375 percent with no closing costs would make plenty of sense.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).