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Interest only loan - freeing cash to pay off school debt

Sat Apr 8, 2006 07:04AM | By Tony

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Note - we have been getting lately many emails about interest only loans. Great seeing borrowers getting more educated about interest only mortgages as there are very few benefits these mortgage products provide and they have to be used with caution, especially now, when real estate market has significantly cooled downed and more still to come. You should not use interest only loans to buy more expensive homes then you can afford with normal fully amortized mortgage. The advice given is for specific case and for your information only and should be considered always in context of an individual. This is the first from the "interest only loan" related questions.

Q: I found a house for $430,000 in upstate New York, I am a Registered nurse with BS in Nursing working for area hospital. I have $86,000 for a down payment after only 3 years of work - great pay, lots of overtime, I averaged $105,000 a year in the last 3 years, ... anyway, I also owe about $60,000 in student loans consolidated at 5.25%. So I have to pay $330 a month for the next 30 years. I want to get rid off this student debt asap, don't like bad debt, bought a used 2002 Explorer with 25,000 miles for $12,300 - paid cash ..., credit score is 665, 689, 712, not enough credit lines for Experian that is why only 665. I consider interest only loan, then I can pay only interest for some time and whatever I save, to put toward student loan principal. One mortgage broker recommended 5 year interest only adjustable mortgage with 6.625% rate. Seems a bit high, and I have to pay closing costs, I am shopping around, another thing I like this area, want to settle down here, plenty of hospitals and nursing homes around, my girlfriend I will marry is from the area. I want your opinion on the interest only and fixed vs. adjustable mortgages. Sorry I wrote that long, thanks.

A: You do your homework, evidently. Congratulations on savings and good credit. First, this mortgage broker wanting 6.625% should at least cover some of the closing costs, not sure what they are in New York state. You can get 6.25 - 6.375% with 30 day lock right now in New York state for 5/1 ARM interest only, if you pay closing costs. With your 20 percent down, credit and salary, you have no problem qualifying. Let's see the math - your mortgage will be $344,000. With 6.375% on a interest only loan you will pay $1,827.50 per month. You save about $320 compare with a fully amortized 5/1 ARM. You can use these $320 towards you student loans, but few things to keep in mind:

$1,827.50 per month is only for the first 5 years which is fixed period of your interest only ARM. After that, if you don't pay any principal and you stay in the house without refinancing this interest only mortgage, your still-remaining $344,000 will be amortized over remaining 25 years, not 30 anymore. The interest rate may go up and you should consider the worst case scenario, so add 2% to the initial rate - and the result is 25 year adjustable fully amortized loan of $344,000 at 8.375%. Your payment will go to $2,741.06 a month and will stay this way likely for the full one year or two, depending on the program. And only $319 going to the principal.

You want to stay in the area, so why not consider 30 year interest only mortgage. Most of 30 year interest only loans are 10/20, that is, you pay interest only for 10 years and then, your remaining balance will amortize at the same rate over 20 years. The payment could be higher in this case because of 20 year vs. 25 in 5/1 ARM (but not necessarily), but you have fixed rate. And the kicker is the long term mortgage rates are now very close to short term or adjustable rates.

You can get 30 year interest only mortgage with 10/20 amortization at about 6.75%. That means you can pay $1,935 for the first 10 years, instead off paying $2,174 with regular 30 year fixed rate mortgage which you can get in New York today at a bit lower 6.50%. That saves you $239.31 a month. Again if you don't pay anything into home loan principal, you will end up with $344,000, 20 year loan, but at the same 6.75 rate. The payment will be $2,615 a month, with $681 going towards principal - a much better scenario.

For your information, 30 year fixed interest only rate mortgage with 15/15 format is available with some lenders. You can pay interest only for the first 15 years and then full principal is fully amortized over 15 years.

I would strongly consider 30 year fixed rate mortgage with interest only provision for the first 10 years.