Refinancing into an interest-only mortgage

Dear Dr. Don,

Q. I own a home in the 20176 ZIP code, worth $500,000. I owe $300,000 on the first mortgage and $80,000 on the second mortgage. I plan to be there another 15 years, but I need money now in pocket.

What is an interest-only loan? I think I should do this for $400,000 to get out of debt and have more monthly money?

Thank you, - Nan Notes

Dear Nan,

A. OK, you got me to look. You live in the Greater Washington, D.C., metropolitan area, somewhere in or around Leesburg, Va. I spent a few years in Northern Virginia myself in the late 1980s. I hated the traffic then, but I'm sure it was positively bucolic when compared to the traffic today.

Replacing $20,000 in debt with $20,000 in mortgage debt isn't getting you out of debt; it's just restructuring your debts. Replace credit card debt with interest-only mortgage debt, and you're postponing repaying that debt as well, so it's keeping you in debt longer.

You didn't say your debt was credit card debt, but I'll make that assumption. If you turn around and run up those lines of credit all over again, any relief you feel in your monthly budget will be short-lived.

The monthly mortgage payment for a conventional fixed-rate mortgage is self-amortizing. That means the monthly payment contains both the monthly interest expense and a contribution to principal that allows the mortgage to be paid off over the life of the loan.

An interest-only mortgage doesn't have the principal repayment component, at least not in the early years of the loan, so it allows you to minimize your monthly mortgage payment. An interest-only mortgage can help a homeowner qualify for a bigger house or free up funds for other purposes.

Interest-only mortgages are commonly adjustable-rate mortgages, or ARMs, but they can also have a fixed initial term. Bankrate provides quotes on 3/1, 5/1 and 7/1 interest-only ARMs, but lenders might offer other options. Matching the time you plan on being in the house with the initial rate on the interest-only loan isn't feasible in your case, since you expect to be in the house 15 years.

Restructuring your debt to interest-only debt can free up some financial slack in your monthly spending plan, but that slack comes at a pretty big price. You'll take on the interest rate risk of an adjustable-rate loan, the closing costs associated with a new first mortgage and stop paying down your loan balances.

You free up roughly $550 per month in your monthly budget with the interest-only loan. You've also reduced your interest expense by about $6,000, with the lower interest rate on the loan, but have done nothing about paying down your loan balance. (I've ignored any impact on your income-tax deductions.)

I wouldn't recommend this approach unless you were up against it in meeting your monthly bills. Even then, using a second mortgage can be an easier approach than totally restructuring your debts. Keep in mind you'll pay a few thousand dollars in closing costs to get a new first mortgage and only a few hundred to get a new second mortgage.

Spending thousands to restructure $20,000 in nonmortgage debt doesn't make a lot of sense. If a little budgeting and belt tightening can get you though this, and the interest rates on your existing loans mean that refinancing wouldn't make sense on its own merits, then look at getting a second mortgage instead.

What are people saying about mortgages today:

Rates on 30-year mortgages edged down last week to a seven-month low. Mortgage-giant Freddie Mac reported Thursday that 30-year, fixed-rate mortgages fell to 6.3 percent, down slightly from 6.31 percent two weeks ago. It put rates at the lowest level since they were at 6.24 percent the first week of March.

Bank of Hawaii, Central Pacific Bank, Territorial Savings Bank and Wells Fargo Home Mortgages all cut their 30-year mortgage rates to 5.75 percent this week.

Most people think of a mortgage as a means to an end. After all, you buy a house, not a home loan. But a mortgage is much more than the path to homeownership. It is a financial instrument that must be managed, just like any other financial investment.