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The Interest in Interest-Only Mortgages

by Kristi  Shibata
Mortgage Directory Columnist

Being able to finance a home is one thing; learning how to use your home as an investment is a whole new game. Savvy homeowners may frequently refinance to achieve their financial objectives. In many parts of the country, borrowers average about 5 years in their homes before trading up or moving on. This mobile tendency is reflected in a preference for shorter mortgage terms (like 5/1 or 3/1 hybrid adjustable rate mortgages). Other homeowners take advantage of lower introductory rates while planning to refinance once the interest rate resets. And still others take advantage of option ARMs and interest-only loans to free up cash for other investments.

Refinancing to Interest-Only Mortgages

Homeowners refinance for a variety of reasons like payment reduction, consolidating debs, and improving the rate or terms of their loans. Interest-only options can be added to both ARMs and fixed rate mortgages.

Interest-only mortgages are just what they sound like--you only pay the interest due each month. Because you aren't reducing the principal balance of the mortgage, your payment is lower for a number of years. At some point, generally 5 to 10 years into the loan, the payments are recalculated so that the loan will be paid off over the remaining20 to 25 years.

How an Interest-Only Refinance Plan can Work For You

By refinancing to an interest-only mortgage plan, you control more of your money. Since you are only paying on interest, monthly payments are lower than traditional mortgages. The extra cash is available for other investments, such as starting a new business or paying for school.

Most homeowners who refinance with an interest-only mortgage may stay with this plan until the interest-only term ends or they can begin paying the loan down and accruing equity. Others make the lower payment for the entire interest-only term and then switch to the higher payment. Still others sell their house or refinance again.

Avoid Interest-Only Traps

If you refinance to an interest-only mortgage, be prepared for the following:
  • Increased payments - If you plan to stay in your loan after the interest-only term expires, you might experience "payment shock." Know what the increase in monthly payments will be and be ready to pay up or get out.
  • Refinancing with an ARM - If you choose an interest-only ARM, your rate and payment move with financial markets and can change throughout the life of the loan. If you want to cash in on low interest rates, prepare to deal with the possibility of higher payments when the interest rate eventually resets.
  • Building home equity - Many homeowners who choose interest-only refinance hope that the appreciation value of their home builds equity while they save on lower monthly payments. Recently, home prices fell in many markets and borrowers found themselves unable to refinance out of loans when the payments increased. Hoping for appreciation has proven to be an unreliable strategy.
No mortgage product is right for everyone. Interest-only loans and other products that offer lower initial payments can do some damage to less knowledgeable homeowners but have a place in the portfolio of savvy investors.

HSH Associates

About the Author
Kristi Shibata is a public relations and communication specialist and regular Mortgage Directory columnist. She graduated from University of California, San Diego, with a BA in Communications.

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