Monday, June 27, 2005

Lemonade from a Lemon: How to Take Advantage of Interest-Only Loans

In a recent post I was quite critical of interest-only loans (such as the one Quicken is promoting in radio ads). For a small number of people who are VERY disciplined in their spending; it is possible to use this type of loan to advantage if they are offering a large enough rate incentive.


[1] Budget for the following: interest, principal (remember, these folks would just as soon you forget this), taxes, homeowners' insurance, and (if less than 20% down) PMI.

[2] Plan on paying 1/120 of the original house purchase price EACH month until 20% is reached. Then, remember to contact the lender to have PMI removed.

[3] Plan on repaying the entire loan in 15 years (perhaps 18 if you have a very steady job (such as working for the U.S. Government)).


[1] Apportion no more than 40% of income at ANY month to repayment. For most months, the maximum should be 35%.

[2] Do not use an interest-only loan unless you can reduce the interest rate by 1.5%. Also, do not use if prepayment penalties or other significant restrictions on prepayment of principal apply.

[3] Do not use an interest-only loan if you have dependents or if you are at all inclined toward impulse buying.

[4] Do not use an interest-only loan if the economy where you live is stagnant or declining.


Joe and Martha Williams earn $60,000 per year and take home (after taxes and other withholdings) $3,800 per month. They put 10% down on a $120,000 home (assume all closing costs paid by seller) for a mortgage of $108,000. The interest only loan has a 3% annual interest rate. PMI is $60 a month until the mortgage balance reaches $96,000 [(100%-20%)($120,000)]. Combined taxes and homeowners insurance: $2,400 per year (assume an escrow account is available for no extra charge).

Recommended strategy:
For the first year: Average loan balance $102,000 [($108,000+$96,000)/2]. Maximum balance $108,000. Interest rate per MONTH 0.25% (3%/12). Interest first month $270 ($108,000 *0.25). Average interest $255 ($102,000*0.25%). Monthly principal repayment: $1,000 ($120,000/120).
First month payment: $1,530 ($1,000 principal + $270 interest + $200 taxes/insurance + $60 PMI). This is 40% of monthly take-home, right at maximum. Additionally, most people making $60,000 probably are going to want a home costing at least $120,000 in the present real estate environment. For the year as a whole the monthly payment will average $1,515 (1000+255 interest+200+60) which is still close to 40%. Each potential buyer will have to envaluate whether they can reduce spending enough in other areas to cover the extra housing spending the first year.
For the second year, PMI can be cancelled and the repayment of principal could slow to 1/150 of house cost and still meet the 15 years recommendation. Interest in thirteenth month (first month of second year) is $240 ($96,000 * 0.25)--it will slowly decline (about $2.50 per month) thereafter. Principal repayment is now $800 per month ($120,000/150). Now the repayment in month 13 is $1,240 ($800 principal + $240 interest + $200 taxes and insurance) which is a more comfortable 32-33% of monthly take-home. If taxes and insurance do not change (far from a sure thing--then again, wages will be probably increase), the payment will slowly decrease to about $1,000 per month when the loan is paid off halfway through year 14.

The big questions then come back to: [1] Can you discipline yourself to pay back principal when it is not required?, [2] Can you be happy (or at least content) in a house that fits your take-home pay?


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