Are Interest-only Home Loans Good For Military Families?
Recently, interes- only home loans received plenty of negative press. The criticisms focus on the supposition that homebuyers will never make principle payments, and thus, never build equity in a home or own a home. Additionally, criticisms extend to loose underwriting practices and unacceptable increases in monthly payments at the end of the adjustable rate. All of these critiques have some validity, but there are times when interest-only home loans are an appropriate choice for military families.
First, let's compare the structure of the interest-only loan to a traditional conventional loan.
As the name implies, the interest-only loan requires interest payments only on the loan balance. Most -- if not all -- interest only loans are also adjustable rate mortgages or ARMS. ARMS lock in the interest rate for the initial term of the loan, which can last one, three, five, seven or 10 years. At the end of the initial term, the rates will usually adjust upward. For example, a 6 percent, 5/1 interest only ARM means that for the first five years, the buyer will pay interest only at percent. Most interest-only loan products do not have a prepayment penalty. Thus, if you make additional payments on the principle loan balance, your subsequent monthly payments will be reduced because the loan amount has decreased.
In contrast, the more traditional conventionalloan requires interest payments on the unpaid loan balance in addition to amortized principle payments over a specified period, usually 30 years. The monthly payment remains the same, but the amount paid towards the balance gradually increases while the amount of interest paid gradually decreases over the life of the loan. The traditional conventional loan can either have a fixed rate for the life of the loan OR be an ARM with terms similar to interest only ARMs. Note that the actual interest rate on the "traditional conventional" loan will usually be slightly lower than on the interest only loan products.
Example: Comparison of interest only versus traditional conventional loans
Amount of $300,000 at 6 percent
5/1 interest only ARM
The monthly payment is $1,500
Traditional Conventional Loan
Loan Amount of $300,000 at 5.5 percent
5/1 ARM for 30 years
The monthly payment is $1,703
The difference between both loans is $203 per month.
Note: For comparison purposes, examples do not include property taxes, hazard insurance, condo or homeowners association fees.
Military families should consider Interest-only loans:
- When you do not expect to stay in the home beyond the initial ARM period.
- When you are buying in an area where you can reasonably expect homes to appreciate at a modest to above average rate.
- When the reduced monthly payment is required to qualify for the loan.
- For budget flexibility.
Finally, everyone is aware of the tax advantage that home ownership provides over renting -- homeowners can deduct the loan interest. Some disciplined military home owners have found that interest only loans gave them the opportunity to commit the difference in monthly payments -- $203 in our example -- to a tax advantaged retirement vehicle, such as a 401K, IRA, or TSP. (Check with your accountant and financial planner.) However, interest only loans are probably not the optimum choice for homebuyers who intend to live in the home for lengthy periods or who desire to ultimately pay the loan off.
Regardless of the type of loan, there is no substitute for financial discipline and thoughtful budgeting. You should carefully select your loan company and loan officer. All loan products should be thoroughly understood before signing on the dotted line. There are numerous perils associated with equity loans and rolling consumer debt into "the roof over your head."