Why would one consider a “Smart Choice” (interest only) mortgage loan? Why not rent and save the funds? Here are a few of the facts, and additional resources to consider.
More often than not, these types of loans are entered into with the intention of saving the amount that would have gone to principal, but it usually doesn’t happen, for one reason or another. The “interest only” period is usually set for a specific amount of time; generally 5 years, but can be 10 years. If you elect to use the option of “interest only” payments, you should understand that your note balance at the end of the term will be the same as the day you closed on your home. Granted, you may have a Deed of Trust, or similar document on file with the courthouse, but if the market value in the area you purchased your home has declined, you are left in a black hole.
A similar sort of program was initiated years ago, for the purchase of autos. It is called “Smart Buy”, pretty much meaning more ‘bang for the buck.’ It allows those with limited income and/or bad credit to purchase a newer year vehicle and make low monthly payments, which is attractive to these individuals. They pay no heed to the consequences of the contract, which requires a balloon payment at the end of the loan term. Many times it is in the area of $9,000 or more.
Both the “Smart Choice” mortgage, and “Smart Buy” auto loan potentially deny the buyer any equity, whether for 5-10 years, or at all. So why not just rent or lease, if that is the case? I know two situations in which it may be feasible to enter into an “Interest Only” mortgage:
- The home being purchased is well below market value, and due to the inflated real estate prices in the location, there is a potential for considerable equity in 5-10 years, at which time the home can be sold, if desired.
(my brother and his wife bought their home in Fort Worth, FL in 2000 for $200,000. They have a conventional mortgage, but the current market value of their home is $650,000. Had they chosen an interest only loan, they would be well ahead if they chose to sell.)
- A young couple or family, knowing they will need a larger home in the near future, but are limited on funds at the moment. This allows them to buy the home they want, and when their earning potential increases, they can make the principal payments, as well as the interest.
An example of the detrimental effect of this type of loan follows:
A mortgage is taken for $100,000, for 30 years at 6.25% interest. Considering the convential loan v. the “interest only” loan, on the 11th year (interest only was exercised for 10 years), the results would be.
Conventional Loan Interest Only Loan
Payment Amt $615.72 $520.83
Pmt on 121st month $615.72 $730.93
Balance of note,
121st month $84,060.00 $99,790.00
You can note the detrimental effect that this type of loan has on any equity, considering that the market value had remained the same. To sum it up, do plenty of research before considering this type of loan. Take into consideration:
- Other options
- Current and anticipated earnings
- Economy and market in the area you are interested in
Buying a home is one of the biggest decisions in one’s life. Choose carefully and weigh all pros and cons of financing options. Ask plenty of questions, and do your homework. Good Luck!