Example:
Let’s say I have an interest-only loan for $500K that I took out last year and resets 4 years from now and the current rate is at 5.625%. The interest-only payment would be 2344 per month.
Let’s say that this loan has a fully amortized rate of 7.656% if it were to reset to today’s 1-year T-bill plus a margin of 2.75%. (See E-loan.com)
Let’s compare that to todays 30-year fixed rate, NO-cost loan (for simplicity) at 7.75%. Payment is 3582 / month.
Since I am not clairvoyant I don’t know if rates will be higher or lower 5 years from now, though I’ve seen arguments both ways. Right now am I better off paying an additional $1238 per month for 48 months for a total of $59,424 ?
In what scenario would this make sense ?
Case 1. Rates stay the same. No brainer here. Better off not paying the $59K. Keep the IO
Case 2. Rates drop. Another no brainer. Saved the $59K PLUS I would pay less than what I would have with the fixed at todays rates.
Case 3. Rates Rise a couple percent
Let’s say rates go up by 2% from TODAY’s rates at the time of re-set. That would make my fully amortized rate at reset 9.656%. With 25 years left on the loan my payment would skyrocket to 4422 (from 2344 in the IO period). A payment increase of 2078. It would take 28 months (59,424/2078) to get to the point where one would break even with the fact that I overpaid for the 30-year fixed for 4 years. So, 48 months more on the IO, plus 28 months = 76 months or nearly 6.5 years, for the two scenarios to break even. This ignores the time value of the 59K. Let’s assume that amounts to the equivalent of a few more months to break even. This hurts a little, but it happens over a 6-7 year period.
In 6-7 years how much will my income increase ?
If I am on a professional career path, and interest rates are higher than they are now, it’s a safe bet that I will keep up with inflation, so assume 4% raises over 6 years, annual compounding gives me an increase in my wage of about 26% over this period. If I could service the original loan with 35% of my income, then I am in good shape.
Case 4. Rates rise explosively.
The CAP in the original IO would typically be 5% above the original rate. SO if rates skyrocket beyond that, the person is sitting pretty with a “low rate” loan at 10.5%), when everyone else is paying 14%.
