Refinance To An Interest Only Loan?

March 7th, 2010

I always felt like an “Interest Only” loan (where you pay no principal and are only making the interest payments on the loan) was like taking your house and putting it on a credit card. I was never a big fan of these loans, and as a result never did many because clients always sensed my unease, and ended up going to the competition who talked these loans up as a great way to “get in the market.”

I thought the Interest Only loan has been put to bed, and no one was doing them anymore. I did not think any client wanted them, nor did I think many banks offered them. But, I was surprised when an old client of mine said he was approached by a lender to refinance from his fixed rate mortgage to an Interest Only loan. Huh? Why take a loan (which was already at a decent rate, by the way) where you were paying the debt down, and put it on a credit card?! I was astonished. Here was the exchange:

“Brian, I’m at 5% on a 30 Year Fixed on about a $335K balance that you got me. House worth about $450K now per Zillow. Going to retire and move out in about 5 years. Another broker called to offer me an interest-only 7-year adjustable Interest Only at 4.5% or 10-year adj. IO at 4.75%, with about $5500 closing costs, including new escrows. What do you think about a 7 or 10-y adjustable
interest-only. I didn’t want to go any further without checking in with you for an honest opinion and a shot at a deal if it’s a good idea. I have a hunch that if it were a good idea you would have mentioned it already; so I’m suspicious of the offer from the other broker.”

My reply:

“Wow, I did not know lenders are that hard up out there. That is a guy who is on a fishing expedition, that is all. And shame on him. He is probably one of those “list buyers” and your name is on a list of people that have between 5% and 6% mortgages. And they use different strategies at different rate levels to try and convince people to refi. At 5%, they know your rate is not that bad, so they trot out ARM’s and Interest Only loans.

There are brokers out there who are trying to create deals out of thin air, by convincing people (and sometimes it is an easy pitch in this very tough economy) to refi off of their fixed rate loans to an Interest Only loan. The lower payment sounds great, but why would you put your house on a credit card, which is effectively what you are doing with an Interest Only. You are only reducing your payment by stopping the payment of principal.

And taking a regular, amortized ARM may make sense, if there was enough savings, but there is not. I would have already crunched those #’s. If you are at a 5% Fixed Rate now, and he is offering you an ARM at 4.75%, there are no savings in interest. If the monthly payment is going down that is only because you are starting the clock over again on a new 30 year loan, and using the lower balance that you have paid down to, as the new starting point. That is called robbing Peter to pay Paul.

If you want to take a risk, and gamble that you’ll be gone in 5 years, I’d do a regular amortizing 5 Year ARM. I have a regular 5 year ARM at 3.875% with 0 points. So you’d have 3.875% for 5 years, and then a possible adjustment. Going from 5% to 3.875% would save “real” money, however there would still be some “robbing Peter to pay Paul affect”. But, if you really want to save cash flow, its a thought. But don’t do an Interest Only loan, if anything, consider an amortizing 5 year ARM.

I ran the #’s and this would drop your payment a good bit, keep yourself on an amortizing loan, and give you 5 years of fixed rate at 3.875%. But are you sure you want to trade away a fixed rate for monthly savings and an ARM? I am pretty conservative, so I usually don’t think to talk to people about ARM’s, but if you are sure you’ll be gone in 5 years, maybe the risk is limited?”

His last reply:

“No, I am conservative too. I already take enough risk in the stock market, there is no need to take risk on my mortgage. I’ll keep my great 5% 30 year fixed rate mortgage, and keep paying the debt down. And who knows, I may not be able to retire in 5 years the way things are going, so your reply is the right one. Thanks for talking it through, I can always count on you for an honest assessment.”

There “may” be times when refinancing to an “alternative’ mortgage makes sense, but for the most part when I go through someone’s scenario, I find that the discussion of an ARM or an Interest Only loan was caused solely because some lender who was trying to “make a sale” and not because they had the best interests of the client in mind.

Brian Martucci is a loan officer for Capital Bank Home Loans, a division of Capital Bank, N.A. He has been in the mortgage industry since 1986 and has served in a number of roles, including loan processor, loan officer, mortgage broker, branch manager, and vice president. Brian Martucci – NMLS# 185421. His opinions do not necessarily reflect the opinions and beliefs of Capital Bank Home Loans or Capital Bank. Capital Bank, N.A.- NMLS# 401599. Click here for the Capital Bank, N.A. “Privacy Policy”.

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