Invest the Cash Flow Savings on an Interest-Only?
November 20, 2006, Reviewed July 21, 2009

"I am considering the 6.375% interest-only version of a 30-year fixed-rate mortgage, as opposed to the standard version at 6.25%. My idea is that if I can earn more than 6.375% on the cash flow savings, I should end up ahead. True?"

No, you have to earn more than 8.35% to come out ahead.

If you take the standard FRM, the fully amortizing monthly payment at 6.25% is $1847.16, and after 10 years, your balance would be $252,712. You would thus pay down the loan balance by $47,288 over the 10 years.

If you take the interest-only version of the FRM at 6.375%, and don’t make any principal payments, the balance after 10 years remains at $300,000. The interest-only payment is $1593.75, or $253.41 less than the fully-amortizing payment of the standard mortgage. To break even, therefore, the monthly cash flow saving of $253.41 must accumulate to $47,288 over the 10 years.

The break-even rate of return is 8.35%. This is the rate that must be earned on the monthly investment of $253.41 to generate a fund of $47,288 in 10 years. It is higher than the rate on the interest-only because it must offset the interest rate difference between the interest-only and the fully-amortizing versions.

To come out ahead, you must earn a return greater than 8.35%. Few people can do that without taking a lot of risk.
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