Friday, June 24, 2005

Why wouldn't I get an interest-only loan?

Ah...interest only loans...the new thing in financing your real estate purchases. With such low, low payments, how on earth could it go wrong?

When it is a good thing:
1. You are an investor and plan to sell your property within a year. You want to keep your payments as low as possible and you aren't worrying about the market changing much before you sell it. You should be fine then. If you are improving your property or betting on high appreciation before you sell short-term, this should work for you (but if you sell before a year is out, you will be taxed on short-term capital gains - very high compared to selling after a year where long-term capital gains is capped at 15%).

When it is NOT a good thing:
1. You are planning on keeping the property for less than 5 years: In this case, interest only loans carry a moderate amount of risk. You are betting that the house will appreciate enough in the time before you sell it. Don't forget the other costs that you will have to cover to just break even...about 3% in closing costs to buy it and about 7.5% to sell it. You will have paid no principal by the time you sell it, so unless your property has appreciated, you could end up owing more money than the amount of the loan just to get it off your hands. And are you SURE you know where the market will be in a few years?
2. You are planning on living there more than 5 years and want this loan because otherwise you could not afford this property: This is definitely NOT an optimal choice for you. Besides the same comments as in #1, you could be even more hurt because, all of a sudden, your interest-only loan will start to adjust to the market rate. Not the market rate NOW, the market rate in the FUTURE. The difference between a 6% and an 8% loan on $400,000 is $537/month. If you were stretching now, how are you going to make it then?? Well, you think...just refinance. But what if the rates finally go up and all you can refinance to is a much higher rate (we have had the lowest rates in history recently, so it's probably only a matter of time). Ouch! Just buy within your means.

So, do your homework. Don't just roll with the trends or with what a mortgage lender tells you is the popular thing to do. This is YOUR money and your life. Do your due diligence, and don't be afraid to ask questions.