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Are “Smart Choice” loans really smart?

by Matt Difanis
February 28, 2005

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Many lenders—particularly some heavily advertised Internet loan shops—are now pushing interest only loans as a great way to minimize mortgage payments. Quicken Loans, for example, now offers a “Smart Choice” loan, which offers interest-only payments at a rate that starts as low as a jaw-dropping 1.99% as of this writing. This and other similar programs claim huge savings on monthly payments. One radio ad running for a Chicago area mortgage brokerage hypes the lower payments of the interest-only mortgage as adding thousands of dollars in wealth to your budget each year. Quicken Loans’ site features a photo of a fake satisfied customer, holding a sign that reads “$7,565 difference,” presumably her annual savings compared to a traditional 30-year fixed rate mortgage.

So how smart are these “smart choice” loans? For most buyers, not very.

While it is true that an interest-only loan can provide a mortgage payment up to 40% or so less than the payment for a 30-year fixed rate loan of the same amount, this ostensible savings comes with some major tradeoffs. First is the risk of having a wildly variable interest rate. To get that teaser rate of 1.99%, you must pay half a point (i.e., .5% of the loan amount) on top of the typical loan origination and closing fees. The interest rate then stays fixed for only six months, after which time the rate more than doubles to 4.75%. Since the payment is comprised entirely of interest, the payment amount more than doubles, too. And every six months thereafter, the rate is subject to change according to market conditions. So unless you intend to live in your home for only a year or less (in which case you’re nuts to be considering home ownership), the future of your mortgage payment is a complete crap shoot.

The remainder of the “savings” in the monthly mortgage payment is not really savings at all. In any traditional mortgage loan, the loan is gradually paid off each month. To accomplish this, every monthly payment consists partly of interest and partly of principal. In an interest-only loan, there is no payment of principal, so the payment is lower. But since the principal portion of a loan payment reduces your loan balance, that money is not lost each month. Instead, that portion of your house payment transforms cash in your pocket into increased home equity. In other words, the principal portion of a mortgage payment is not money that is “spent,” just converted to home equity. Since equity buildup is a key benefit of home ownership, an interest-only loan seriously erodes this benefit. Without major appreciation working in your favor, you greatly increase the risk that you will have less money in your pocket after you someday sell the house, compared to your down payment when you purchased it.

If you are likely to be in your home for several years, an interest-only loan will almost surely be a big mistake. Consider a 15- or 30-year fixed rate loan instead. And if you suspect that you will be in your home for no more than five or six years, skip the interest-only loan in favor of a 3/1 or 5/1 adjustable rate mortgage. These loans offer a great compromise between the rates of a 30-year fixed rate loan and the ultra-short-term teaser rate at the beginning of an interest-only loan. A 5/1 ARM is a 30-year mortgage with a rate that is fixed for the first five years, after which the interest rate would adjust annually according to the market. Because the lender is guaranteeing the rate for five years instead of 30, the rate is often noticeably lower than that of a 30-year fixed rate loan. For most people, this is a far better way to save on interest, while ensuring that you will be gradually paying down the balance on your loan.

Are “Smart Choice” loans really smart?

by Matt Difanis February 28, 2005

Matt's Article Archive

by Matt Difanis
February 28, 2005