Interest-only Mortgage: Should You Refinance
Should you refinance your interest-only mortgage? It's certainly worth thinking about, but you need to make an informed choice based on your personal circumstances. Here are some of the key questions you can ask yourself in reaching your decision.
Why Would I Want to Refinance My Interest-only Mortgage?
When you look only at monthly payments, interest-only mortgages (IOMs) are undoubtedly cheaper than other home loans, at least initially. But when you check out the total cost of borrowing over the "term" (length) of the loan, IOMs are pretty much invariably much more expensive. That's because lenders recognize them as riskier, and (no matter how they dress up the offer to look attractive) they need to charge more to cover their added exposure.
For borrowers, that means IOMs have a limited shelf life. They're great for as long as they're answering a pressing need, but the moment that need disappears you'll likely want to refinance.
Do I Still Need an Interest-only Mortgage?
Probably the most common reasons homebuyers opt for IOMs are:
- An IOM lets you get on the housing ladder sooner, something that can be important when home prices are rising sharply
- You can afford a better home than with a traditional mortgage, and that could save you the cost and hassle of moving in a few years
- You have your own business or a sure-fire investment opportunity, and the lower monthly payments allow you to invest your extra cash flow
- You use that extra cash flow to pay down higher-interest debt
- Your income varies and you're going to pay down the "principal" (the amount you borrowed) during the good times
For most borrowers, those pressures last a relatively short time, often just a few years. Once they're past, it's well worth exploring the possibility of refinancing to a more traditional mortgage.
Is My Interest-only Mortgage Harming Me Financially?
Different lenders offer different deals and different borrowers have different circumstances, so there's no one-size-fits-all answer to the question whether you'd be better off dumping your IOM. But here are some common drawbacks you might want to consider. They may be affecting you now, or are a threat looming in the future:
- You're not building equity as quickly. If you're not reducing the balance on your mortgage each month, the only way you're accumulating equity (the difference between the current market value of your home and the current balance on your mortgage) is through rising home prices in your neighborhood. And recent history has taught us that those prices can't be relied on to always move upward. The chances of ending up trapped in an underwater home (with negative equity) are higher with IOMs.
- Many IOMs require you to start to repay the principal at some point, commonly when you're 10 years into your loan. But then your monthly payments are bound to rocket upwards: With a 30-year loan, you'll be paying down the amount you originally borrowed over 20 years instead of three decades.
- You'll pay too much interest. With a traditional mortgage, you begin to whittle away at your principal debt from month one. And a process called "amortization" creates a virtuous circle within which each month the amount you owe falls, the amount due in interest on your ever-smaller debt reduces and the amount by which you make your debt yet smaller increases. With an IOM, that virtuous circle is at best delayed.
- You lack rate security. Many interest-only mortgages are also adjustable-rate mortgages (ARMs), and – usually after an introductory period when rates are fixed – these expose borrowers to all the dangers of floating mortgage rates. Yes, experts have been warning about imminent rises in those rates for years, and have so far been proved wrong. But are you prepared to risk that situation continuing? Currently (July 2016), Freddie Mac is forecasting that rates will average 4.5 percent in 2017. And, also at the time of writing, rates on 30-year fixed-rate mortgages are at a three-year low. Check to see if they've changed by the time you read this.
What Should I Do Next?
Do any of those drawbacks bother you? If so, you should probably keep your options under constant review.
With mortgage rates currently so low, refinancing to a fixed-rate mortgage may be more affordable than you think, especially (though not only) if rising home prices mean you can put together a chunky down payment in the form of your existing equity. And a hybrid ARM may be an even cheaper option, although they're usually best for those likely to move home again within, say, seven years. So now might be the perfect time to get some no-obligation refinance quotes, which will allow you to weigh your options and make that all-important informed choice.