- The Washington Times - Thursday, July 27, 2006

Q:I have read several articles about interest-only loans. One thing they all say

is that an interest-only loan is good for people who don’t plan on holding the home for a long time. Because very little principal is paid off in the first few years of a loan that’s amortized over 30 years, we might as well take out an interest-only loan and lower the payment.

Because we plan on selling within three years, our objective is to tie up as little cash as possible. Do you agree that an interest-only loan is right for us?

A: Actually, I disagree with your planned strategy, although I have read the same articles with the same advice.

Interest-only loans simply swap principal curtailment in exchange for a lower monthly payment. Interest-only loans are fine when the rate is low and the borrower is financially responsible, but to be frank, I have never understood the correlation between an interest-only loan and a short holding period.

Although it’s true that very little principal is curtailed in the early stages of a loan that’s amortized over 30 years, that has nothing to do with the holding period of the property. In fact, I recommend against highly leveraged financing and interest-only payments in cases where the property will be sold in just two or three years.

Why? The answer is simple. In the event of a market downturn, selling the property could result in writing a big check at the settlement table.

Let’s take a look at some numbers.

A property purchased for $350,000 with no down payment and interest-only payments will carry a loan balance of $350,000 until the borrower decides to pay down the loan. Such a plan fits in with your objectives because you want to tie up as little cash as possible.

Now, let’s say you sell in three years. How much does the property have to appreciate to prevent your writing a check at settlement? Real estate commissions typically are 6 percent, and it’s not uncommon in a balanced market for the seller to accept an offer that requires a contribution toward the purchaser’s closing costs. Let’s assume 2 percent. Your total cost to sell the house is equal to 8 percent.

This means that you will have to sell the property for about $380,000 in order to break even — 8 percent of $380,000 equals $30,400, leaving you with $349,600 to pay off a $350,000 mortgage.

Although it is perfectly reasonable to assume that the property will appreciate by $30,000 over a three-year period, it’s certainly not guaranteed.

A short holding period and the desire to put little or no cash into the home have no correlation, except risk. Any asset is likely to appreciate over time but is just as likely to experience dips along the way. By the same token, financing a property 100 percent simply equates to higher borrowing costs over time and a bigger debt to pay off when you decideto sell.

Folks who buy a house with the intent of a short-term hold need to understand that timing the market is much more crucial for them than for folks who buy a house and hold for the long term.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected]pmcmortgage.com).

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