How To Use Interest Only Loans To Your Advantage When Planning Your Finances

• Tweet

One advantage of using interest only loans versus amortizing loans is that it opens the door to more sophisticated financial planning. 

One way in which that's possible is that interest only loan payments are re-calculated each month based on how much money you are currently borrowing. 

The industry term for the re-calculation is "recasting".

For an interest only, the monthly payment is calculated according to the following formula:

(Outstanding Loan Size) * (Annual Interest Rate) / (12 months)

A $400,000 loan size at 6.000%, therefore, yields a monthly payment of $2,000. 

If an extra principal payment is made on the loan, the new loan payment will reflect a new, lower outstanding loan balance.

Therefore, paying an extra $1,000 to a $400,000 interest only loan at 6.000% reduces next month's mortgage by $5.00. 

Now, before you say, "Wow. Five dollars. Maybe I'll go the movies. By myself.", note that $5 per month is $60 annually and $60 is six percent of $1,000. 

The payment savings per dollar "invested" is exactly equal to the interest rate.

This is in contrast to an amortizing loan in which your mortgage payment never changes until the loan is satisfied.  Additional principal payments on amortizing loans shave months from the loan's life, but not its payment.

Car loans work like this -- they take fixed payments until the loan is paid in full.

Recasting is not exclusive to interest only loans, however.  Many lenders will allow you to recast your amortizing loans for a small fee ($100-500) but usually limit the total number of times you can recast over the life of your loan.

By contrast, interest only loans recast every month. Like a credit card, you only pay interest on what you're actually borrowing.  If you're borrowing less, your payments will be less.

Now, before you go rush to pay down your interest only loan because you're paying more in interest (6.000%) than you're earning in your bank account (2.500%), consider three important variables:

1. The tax deductibility of your mortgage interest
2. The opportunity cost of pulling money from other sources
3. The value of being liquid.

Your financial planner is a good starting point for these conversations before deciding to reduce your mortgage balance.

Interest only loans require discipline and are not proper for every homeowner (the same way that a 30-year fixed is not appropriate for every homeowner, either). 

However, within a balanced financial portfolio, they can be a terrific financial planning tool.