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June, 2005 Tax Tip

Consider an Interest-only Loan


With an appreciating real estate market more and more home buyers are turning to interest-only loans.  While these loans can be a gamble since we have no idea of where interest rates or home values may be heading, they may make the difference as to whether thousands of home buyers can indeed realize the American dream.


In some of the faster appreciating real estate value areas of the country, interest-only loans have jumped from around 2% of all home loans to well over 40% in the past three years.  From information I’ve recently read,  about one-half of homes bought in the $250,000 to $300,000 range are currently using interest-only loans, while above $400,000, the majority are using interest-only loans.  If you are a buyer who is very concerned about your payments jumping up at the end of the interest-only phase of the loan, these loans may not be for you.  You would probably sleep better if you had a traditional fixed-rate loan.


Many buyers who go for interest-only loans have indicated their intent to make voluntary principal payments either on a regular basis or whenever they felt they could.  The advantage in so doing allows them to reduce principal (and build up equity), thereby lowering the interest payments while still not being committed to monthly principal payments in the event of unexpected expenses.


As you might expect, there are many types of interest-only loans with interest rates, terms, and time frames that can be tailored to fit a buyer’s needs  This is anything but a “one size fits all” market.  One caveat (and it should be obvious)  - a buyer should have a high confidence level in his loan advisor and ask many questions to make sure he gets the loan that’s best suited for him.  Some questions that come to mind that a buyer should want to know are the number of years he can pay interest only; whether the loan has a fixed or adjustable rate both during and after the interest-only phase; how high the interest rate can rise after the interest-only phase; and whether he can make principal payments in addition to interest during the interest-only time frame.


So who are the buyers that these loans can work best for?  They are primarily buyers who need a low monthly payment to start but know their income stream will be increasing during the interest-only period and buyers who know they’ll be in the home for just a few years.  Poor candidates are those living on fixed incomes; families who will be going from two incomes to one; and those who plan to live in the home for many years. 


In summary, I would say that prudent advice would be to not over-extend yourself during the interest only phase of the loan, unless you are extremely confident of future income and/or other factors.  I realize that this may not be what some buyers want to hear when, in an appreciating market, others are telling them to do whatever it takes before they lose their opportunity.


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