Siren Song of the Interest-Only Loan

A partner at a well-known law firm asked me yesterday if he should refinance his mortgage to a 7/1 interest-only ARM, and use the extra cash flow to buy stocks. Does this strategy survive a risk-reward examination?

My opinion is no. But his question threw me off guard, because it’s more complex than it looks. Here are the issues at hand.

If you’re a homeowner who reads his junk mail, you probably already know about interest-only loans. Terms vary, but generally, these are 30-year adjustable-rate mortgages (ARMs) with a 3 to 7 year “teaser” period in which you pay only interest, no principal, at a low fixed rate.

The stock market returned over 20% last year, while the teaser rate on a 7/1 interest-only ARM is only 5%. So my friend figured he could set aside an extra $1,500 a month by refinancing, and put that money into a rising market. By the time the mortgage went back to adjustible-rate, seven years later, he would be sitting on a huge pile of money — about a quarter million dollars, if current stock market returns hold up. Later, if interest rates had risen, he could use the money to pay down principal. If not, he could continue to invest.

Right? Yes, as far as it goes. The question is, “where are the hidden assumptions?”

Here, the underlying assumptions are (i) that stocks will go up faster than the additional interest you’re paying, net of the tax benefit (mortgage interest is deductible); and (ii) that mortgage rates won’t hit the roof between now and the homeowner’s reversion to variable-rate 7 years from now.

In my opinion, these conditions are far from assured. It’s conceivable (likely, according to some experienced money managers) that stocks will return no more than 5% in coming years. If that happened, and if mortgage rates rose even one or two points in the interim (which is nearly certain), then this re-fi strategy would result in a loss of capital.

One more yellow flag on this strategy is a historical one: the last time interest-only mortgages were this popular was the late 1920s, when homeowners used them to — you guessed it — invest the extra cash flow into the stock market. After 1929, these people lost most of the money they had invested, leaving them with no cushion as the economy went down. Many lost their homes.

OK, maybe there’s no Great Depression coming, and I’m not arguing you’ll lose your home as a result of an unfavorable re-fi. But it is generally agreed that the stock market looks expensive. Investing with your home equity might not be the best idea.

Now, you have to keep in mind that this law partner’s net worth is higher than mine! So consider me a suspect source. As usual, ultimately you just have to look at the respective arguments and make your own judgment.