In the Millionaire Next Door book, the authors provide the characteristics of the wealthy. Many of the characteristics are unlike what we might think profile the wealthy. Specifically, the idea of slow and steady wealth creation and frugal living. These are the ones that stick out for me. Read the book for the others. Now, given that we have research behind the wealth characteristics, one would conclude that many of us would conduct our financial matters in a manner consistent with these findings so as to create wealth. Not so in today’s living!! Somehow, the lessons of the 1920s and Great Depression are far removed. As a refresher, interest-only loans were popular to free up funds for stock investment which as only to later come crashing down with the stock market crash of 1929. How does this relate to today? Well, within the last five years, the world has come full circle only to introduce interest-only loans again and with great success to the masses.

Financial Prison!!! Wow, that is harsh. Ok, for certain people in certain circumstances, it becomes a viable financial tool. Otherwise, Run!! Here are my big six reasons to avoid interest-only loans.

1) If you have to stretch yourself so thin to buy a piece of real estate that would enter an interest-only arrangement, you should really consider both your motive and your overall financial picture.
2) Paying interest only is essentially the same as just paying rent. Why bind yourself if all you are paying for is rent.
3) An interest-only loan is essentially an evolving ARM in a current period of low to moderate interest rates. Why not lock in low rate on a 30yr fixed?
4) A traditional 30 yr. fixed provides a financial safety net in the event that you need to liquidate due to life’s circumstances which could otherwise cause potential financial strain.
5) Most people with an interest-only will not invest or save the money that otherwise would have been paid on a 30 year fixed.
6) Although we can always remain optimistic, we must also be realist. The future is uncertain and thus income growth and home appreciation may fall short.

Ok then, who should invest in interest-only loans? Investment professionals, that is who! These are individuals who have significant assets and use interest-only loans to leverage their existing assets in order to engage in other advantageous, higher return instruments like perhaps equity investments or certain business ventures.

Too many people suffer from financial myopia, nearsightedness, and thus can’t see the long-term perspective. Think about it, the subsequent variable rate impact of the 5 yr. interest-only is a shot in the dark five years from now. Well, I’ll refinance at year five. Oh ok, what at a probable (if not guaranteed) higher rate than fixed rates today!

The tax-effected rate of a 30 year fixed rate mortgage = Cheap Debt!!!!

This entry was posted on Friday, June 23rd, 2006 at 6:36 am and is filed under Individual Taxation, Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.