Should I get an 'interest only' mortgage?

Jan. 14, 2005 — Q: I am a first time home buyer whose job requires relocation every 3 to 5 years.  Is it wise to get a 5-yr interest-only mortgage? Hoping to make the right decision soon. — Casey W., Lexington, Ky.

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A: Not if you can afford a mortgage where you’re paying some principal. So-called "interest-only" loans may sound relatively painless — like a lot of what the financial services industry tries to sell us — because the label conveniently glosses over the fact that you will, of course, eventually have to pay back the principal. (If you come across a loan where the bank is truly asking only that you pay interest for a fixed term — and never pay back the principal — by all means take them up on the offer.)

One of the main reasons for owning a home is to build equity, and you can’t do that with an "interest-only" mortgage. If you’re living in a part of the country where real estate prices are rising, you’ll likely build some equity from that rising value. But paying principal is like “forced savings” — which makes it fairly painless.

You might consider an adjustable mortgage with a 5-year fixed term. You’ll get the lower rates of an adjustable, but still enjoy the security of knowing that your payments won’t go up during the first five years. According to Bankrate.com, the average 30-year fixed loan at this writing is going for 5.33 percent, while the so-called “5/1 ARM” will cost you 4.51 percent.

So let’s do the math. A conventional 30-year fixed mortgage at 5.33 percent will cost you $557 a month for every $100,000 you borrow. The 5/1 ARM at 4.51 percent for the same amount will set you back $507 a month, saving you $50. The interest only loan, at the going rate of 4.68 percent, will cost you $390 a month, saving you $117 a month compared to the 5/1 ARM.

Now let’s see what happens at the end of the five years — when you get that promotion that sends you packing. With the interest-only loan, you will have saved $117 a month for 60 monthly payment, or $7,020. But with the ARM, you will have paid down the principal to $91,171 — for a savings of $8,829. (You'll get some additional tax savings from the interest-only mortgage because of a slightly bigger deduction for interest payments. At the 15 percent tax bracket, that savings will amount to less than $300.)

Interest-only loans may make sense if you use the extra cash for an investment that yields greater returns than housing — though the way house prices are rising in many areas, that's pretty hard to find. But if the extra cash to buy, say, a pricey vacation — or more house than you can afford — it’s probably not a good idea in the long run. Because you’ll eventually have to pay back that principal.