Real Estate Mailbag

Interest-Only vs. Option Loans

By Robert J. Bruss
Saturday, September 10, 2005

Q DEAR BOB: We have a 4.875 percent adjustable-rate loan, but another bank offers 4.25 percent "interest only." Is this a good or bad deal? -- Vincent P.

ADEAR VINCENT: Interest-only mortgages have become extremely popular with home buyers and homeowners seeking to minimize their payments. An interest-only loan is usually an adjustable-rate mortgage with the monthly payment locked in for a specified term, such as 12 months. After that, the payment adjusts, depending on its index plus a margin, like all ARMs.

There are pros and cons. If you expect to stay in your home less than five years, an interest-only mortgage keeps your monthly payments at fully tax-deductible rock bottom. You won't be paying down the principal balance but, if you will be selling in five years, who cares?

However, many interest-only mortgages have negative amortization. That means your interest-only payment remains fixed for the specified term, but the ARM interest rate adjusts monthly or semi-annually. Any unpaid interest is added to the principal balance. You could end up owing more than you borrowed.

A variation on interest-only mortgages is the option mortgage. That means the homeowner has the option of paying only the interest, or partially paying down or amortizing the balance, or fully amortizing the mortgage balance.

The option mortgage would be desirable if you expect to stay in the home many years but can barely afford the interest-only choice now. If you expect to earn more in a few years, you could later start amortizing the mortgage to pay down the balance.

DEAR BOB: I have been reducing my 15-year, 5 percent interest-rate mortgage by paying extra principal each month. My friend says I shouldn't do that because I won't save much and I am better off investing elsewhere, as I have 13 years left. -- Kevin L.

DEAR KEVIN: I think you are a smart investor. Every time you pay extra principal to reduce your mortgage balance, you just made an investment earning 5 percent. Ask your friend if he or she knows of a better, safer investment than building equity and saving 5 percent interest on your home mortgage.

DEAR BOB: My wife and I own a second house in Connecticut where our son, his wife and their children live rent-free. Last year, we added our son and daughter-in-law to the title. We are still on the title, and we pay the property taxes and mortgage payments. The state of Connecticut sent us a letter indicating we might owe gift tax. We thought since we are still on the title and pay the property taxes and mortgage, this is not a gift. Do we owe state gift tax? -- Robert N.

DEAR ROBERT: I am a lawyer in California but not in Connecticut, so I can give you only a general answer. If you gave away a specific interest in the property, such as 50 percent, you might owe a state gift tax. However, if you added your son and daughter-in-law as joint tenants with right of survivorship to avoid probate when you die, no gift tax is normally due because you might survive the donees.

However, the federal gift tax situation is clear. You and your wife can give away a total of $1 million during your lifetimes without owing federal gift tax. But gifts exceeding $11,000 per donor per donee per year require you to file a federal gift tax return even if no gift tax is due. Also, the total of your exempt lifetime gifts up to $1 million will be subtracted from your federal estate tax exemption, currently $1.5 million per person if you die in 2005.

Consult a tax adviser for details.


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