The consequences of interest-only mortgages

Q: What are the positives and negatives associated with an interest-only mortgage?
K.J., via e-mail

A: Interest-only mortgages let you pay just the interest portion of a loan for an initial period of time, say the first 10 years of a 30-year loan. After this, your payment rises, taking into account the principal due.

This arrangement appeals to people looking for additional cash flow or increased leverage (to buy a more expensive house). Many borrowers obtain these loans with the idea of selling or refinancing the home before the payment adjusts upward.

The biggest downside is that during the interest-only period you don't build any equity in your property, says Bryan Wayt, a certified financial planner in Austin, Texas. This may not sound bad, since much of any early mortgage payment goes toward interest anyway. But if home values drop when you need to sell, you're on the hook for any shortage.

A key issue is what to do with the money that would have gone to principal. You might use that extra cash to enjoy an enhanced lifestyle, but that would be tough on your net worth, Mr. Wayt says. He recommends putting the money toward other financial goals, such as boosting your 401(k) contributions or building an emergency cash reserve of three to six months of income.

Q: We will soon move into a retirement community that costs about $5,000 per month. We have substantial funds, and would like to earn more than the monthly cost by investing. What is the safest place to invest, yielding a reasonable income without much volatility?
Name withheld, via e-mail

A: There are only three ways for you to go: cash, bonds, or stocks, says Steven Landis, a certified financial planner in Columbus, Ohio. Since you want income with reduced volatility, you should focus more on cash and bonds and less on stocks.

Mr. Landis suggests "laddering" certificates of deposit or bonds with varying maturities (6-12 months apart) and interest rates. This step lets you obtain a blended rate that is higher than short term but lower than long term. In addition, a portion of your principal will come due every few months.

Next, Landis suggests Treasury Inflation Protection Securities (TIPS). Issued by the US government, these protect you against inflation as measured by the consumer price index. When the CPI rises, so do principal and interest payments on TIPS.

Finally, consider short- and intermediate-term bond funds. They provide a diversified portfolio of bonds and professional management - and can be bought for less than it would cost to buy individual bonds. Also, bond funds give you quick access to your principal with no penalty if you need cash quickly.

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