It’s a common situation: You don’t want to wait ’til retirement to enjoy that log cabin in the mountains, but you can’t comfortably carry two full mortgages. Or maybe the kids’ tuition is draining your bank account. It may seem as if building your dream home is just that – a dream. But for some, taking out an interest-only loan can help make it a reality.
Sound intriguing? You’ve just discovered why interest-only loans are the latest buzz in lending circles. Although these mortgages aren’t new, their payment flexibility has made them much more popular in recent years.
"Borrowers who opt for interest-only loans tend to be financially savvy clients with good credit," explains Andrew D. West, financial advisor and partner in the West/Pincombe Group, which offers mortgage financing for log homes through Merrill Lynch. "They are people who have better uses for their money than paying off a 6-percent fixed-rate mortgage."
How & Why It Works
Interest-only loans fall under this creative-financing umbrella. By combining interest-only payments with lower ARM rates, lenders can offer monthly payments that are hundreds of dollars lower than the payment for a traditional fixed-rate mortgage.
Here’s a hypothetical example: A $205,000 home with 30-year fixed-rate mortgage at a rate of 6.25 percent would require monthly payments of $1,262.22. That same $205,000 home with an interest-only loan and 3.25 percent ARM would cost just $555.21 a monthÑa savings of nearly $8,500 a year.
Much like a conventional 30-year fixed mortgage, the interest-only loan can cover both the construction and the permanent mortgage. Many lenders also offer single-close construction-
"By deferring principal, borrowers can improve cash flow and leverage their finances," says Mike Cole with the System-Built division of M&T Bank, which offers loan programs for log home buyers. "It allows people to take equity out of their home early on and invest it to create wealth for the future."
Interest-only home loans come in a spectrum of fixed and adjustable rates and amortization schedules. You may want to use an interest-only option to finance 100 percent of your home purchase and avoid private mortgage insurance (PMI), which is required if you don’t own 20 percent of the home (either in cash as a downpayment or in equity). You can obtain 100 percent financing with two mortgage loans, financing 80 percent with one and 20 percent with a second. Either one (or both) can be interest-only to save you on monthly payments.
Saving Serious Dollar$
Compare an interest-only mortgage at 3.25 percent and a 30-year fixed at 6.25 percent on the $205,000 home: If you upped your payment on the interest-only loan from $555.21 to $1,262.22 a month (the 30-year monthly payment), you’d save $32,335.83 over the conventional loan by the fifth year.
While West points out that these savings are not guaranteed (since the 3.25 percent is an adjustable rate), this example does show how much a consumer can save over the conventional 30-year, fixed-rate loan.
West isn’t the only one urging consumers to consider other loan options. In a recent speech to credit union executives, Federal Reserve Chairman Alan Greenspan suggested that the certainty of fixed-rate mortgages may not be worth the cost.
"Home owners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade," said Greenspan, according to a February 23, 2004, article in The Wall Street Journal. His rationale: although fixed-rate mortgages protect against higher interest rates, home owners generally pay far more (0.5 to 1.2 percentage points) for that protection.
Of course, interest-only financing is just one of many creative options for the modern-day borrower. Check with your financial planner to see what kind of loan you should be taking home.
This article was featured in the December 2004 issue of Log Home Design.