When Interest-Only Might Make Sense

I co-own a condo, and I need to refinance it so it's in my name only. Should I take out an interest-only loan?

Now's a great time to refinance, since mortgage rates are near historic lows. That means you'll have a low monthly payment no matter which type of mortgage you choose.

Since you'll soon be responsible for paying the mortgage on your own, we understand your desire to find a loan with the lowest monthly payment possible. While we aren't in the habit of recommending interest-only products, one could make sense under this set of circumstances. But that doesn't mean it's a risk-free endeavor. (For a basic overview of these loans, click here.)

The potential downside of an interest-only loan is that homeowners are often caught off-guard when their monthly payment jumps after the initial interest-only portion of the mortgage expires. If they can't afford the new payment, they're forced to sell the home. And if the so-called housing bubble pops and property values fall, some interest-only borrowers could find that they owe more money on the loans than their homes can sell for.

But for someone who has $70,000 in equity on a $200,000 home, this worst-case scenario isn't likely. That considerable equity will act as a cushion should the market fall — not even the darkest housing scenarios call for a 35% drop.

Keep in mind, there are many different kinds of interest-only products to choose from. The one that's probably best for someone in a situation like yours is a fixed-rate mortgage that allows interest-only payments during the first 10 years, says Bill Emerson, CEO of Quicken Loans, the nation's largest online mortgage lender. (His company calls it a Smart30, but names vary among different lenders.)

This product gives you 10 years before the monthly payments rise. On the off chance that you decide to stay longer than a decade, you have the peace of mind of knowing that you locked in your mortgage at today's low rates.

Now for the savings: According to Quicken Loans, your monthly payment, assuming an interest rate of 5.75%, would be $623 during the first 10 years. But should you stay in the condo longer than that, the payment would jump to $913. We also ran the numbers on a traditional 30-year fixed-rate mortgage. In today's environment, it would carry a monthly payment of $759.

Another alternative you could consider is a five-year adjustable rate mortgage. This more conventional mortgage offers a slightly lower introductory interest rate than a 30-year fixed mortgage for the first five years, before it switches to an adjustable rate product that adjusts annually. If you were to opt for this, you would pay $718 a month during the first five years based on an interest rate of 5.25%. After that, however, it's anyone's guess, since no one can predict where interest rates will go. But it's safe to say that it would be unwise to gamble that they sink any lower. If rates rise 2%, your payment would jump to $817.

A word of caution: If the only way you can afford to pay the mortgage on your condo is by making interest-only payments, then this is not the right option for you, warns Ron Chicaferro, executive vice president with Thornburg Mortgage, a Santa Fe, N.M.-based mortgage lender. "People should take (an interest-only loan) only if it is used as a tool, not as a necessity." After all, what happens if it turns out you don't move before the payments jump? If you can't afford the property at the more expensive monthly payment, you should get a roommate or sell the condo and move into something cheaper.

Assuming you can afford it, however, here's some good news on the closing costs: You can simply wrap those fees — which shouldn't exceed 1% to 2% of the loan — into the mortgage itself. While you'll pay a higher mortgage since you're financing the fees, interest rates are so low right now that it'll probably add up to just a few extra dollars a month, says Quicken Loans' Emerson. In other words, if the other numbers work out, you don't need to let those pesky fees get in the way of refinancing your loan.