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Enter interest-only loans. As the name suggests, you pay only interest for
the first five, 10, even 15 years of the loan, thereby lowering your monthly
payment by quite a lot. At least initially.
People who calculated what they could afford when rates were 5.25 percent have
realized their mortgage payments are going to be a lot higher now that rates
have gone up, so they're going for interest-only loans."
Problem is, once you do begin paying principal, you'll have to play catch-up to
pay down your debt before your term is up. That means your payments are much
higher than they would have been if you'd simple chipped away at the balance of
your loan all along.
The math says it all
Interest-only loans come in all flavors. With some, you lock in a fixed interest
rate for the life of the loan, while others resemble adjustable rate mortgages,
which carry a fixed rate for a certain number of years and then adjust every six
months to a year.
the most popular interest-only product resembles a 5-year adjustable-rate
mortgage but requires that you pay only interest, no principal, for the first
five years.
The initial savings is pretty impressive.
Let's say you borrow $200,000 using an interest only loan with a 4.75 percent
rate and no principal payments due for five years. Your monthly payment will be
just $791, or about $250 a month less than if you went with a regular 5-year
adjustable rate mortgage with the same rate.
For some, a smart strategy
This is not so say the interest-only loans should be avoided at all costs.
Edelman, for one, has incorporated an interest-only loan into his overall
financial plan. About a year ago he opted for an interest-only loan with a 4.25
percent rate for the first five years. "It's a low rate and it's 100 percent tax
deductible," he said.
But unlike a lot people with interest-only loans, Edelman wasn't looking to buy
a more expensive house than he can afford. Rather, he saw an opportunity to
invest the money he'd otherwise pay in principal. "The strategy is to get your
payment as low as possible and free up extra cash to invest, and I'm convinced
that I'll be able to make more from investments than loan is costing me."
When his payments do go up after five years, he knows he can afford the extra
payment.
If you go the interest-only route, you're wise to set up an automatic deduction
to an investment or savings account. Doing so will dampen the risk that you
spend your savings and make it easier to swallow higher payments down the road.
Interest-only loans also make sense for people whose income is sporadic, either
because they are paid on commission or because they receive annual bonuses. In
this case, they have the option of only paying interest some months but can pay
above and beyond the amount due when they get their bonus checks. According to
Hsieh, there is typically no prepayment penalty on interest only loans.
Of course, this kind of strategy also requires that you're disciplined enough to
sign your bonus check off to your lender rather than taking it to the Caribbean
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