Question: I am considering an interest-only loan and doing as much research as possible. Here's my scenario.

Both my wife and I are professionals with two toddlers. We have steady jobs and don't plan on ever moving from the area where we live. Our next home will be our last. We are looking at buying a home in the $300,000 price range and have saved enough money for a 10 percent down payment. The problem is that we have determined that we can only afford a mortgage of about $175,000, because we have other debts that will be paid off in about two years. Once these debts are paid off, I am confident that we will easily be able to afford a higher traditional 30-year fixed-rate mortgage. Should we take out an interest-only loan and when our debts are paid off, begin to pay down the principal? What do you think?

Answer: I'm a bit skeptical that an interest-only mortgage on a fixed rate will drop your payment enough to meet your comfort level. I'm also worried that you might have trouble finding a fixed rate that offers the interest-only feature. You may have to consider an interest-only adjustable-rate mortgage. Let's dissect your situation and use some real numbers. Here's what we know:

• Your dream home is priced in the $300,000 range and you have at least $30,000 for a down payment.

• Based on 90 percent financing of $270,000, a traditional amortized payment using today's fixed rates would put a financial strain on you until certain other debts are paid off, which will happen in about two years.

• In order to be able to afford your dream house today, you are seeking alternative sources that require a lower monthly payment.

Now let's run the numbers. Since you have 10 percent down, the first thing we want to do is split your financing into two loans in order to keep your first trust limited to 80 percent of the purchase price. Called an "80-10-10" program (80 percent first trust, 10 percent second trust, and 10 percent down payment), it eliminates the requirement of private mortgage insurance.

An 80 percent first trust mortgage would be in the amount of $240,000. You might find a 30-year fixed rate at about 6.25 percent. This would result in a principal and interest payment (P&I) of $1,478 per month. For the second trust in the amount of $30,000, you might find a fixed rate of 6.75 percent, creating a P&I payment of $195 per month.

The combined P&I payment is $1,673 per month. Now let's compare this with an interest-only mortgage.

Most first trust lenders will charge a slightly higher interest rate for the interest-only payment option, but as I said, you may have a bit of trouble finding one. Let's assume you find a first trust "i/o" option that carries a rate of 6.50 percent. Typically, these programs allow the i/o feature for the first 5 or 10 years. Thereafter, you must make steady payments towards the principal balance.

The i/o payment on a $240,000 loan is $1,300 per month ($240,000 X .065 divided by 12 months). Most second trust loans will carry an i/o feature without jacking up the rate. The second trust i/o payment is $169 per month ($30,000 X .0675 divided by 12 months).

The combined interest-only payment is $1,469 per month. This reduces your monthly obligation by $204 per month. Is that enough? You see why I'm skeptical that such an arrangement may not drop your payment enough to meet your comfort level.

You have indicated that until your other debts are paid off, you can afford a traditional mortgage of $175,000. Using 6.25 percent over 30 years, this loan amount would require a P&I payment of $1,078 per month.

It appears that using a fixed-rate i/o mortgage program, we are $391 away from your payment goal ($1,469 minus $1,078).

Enter the world of adjustable-rate mortgages (ARMs). You have many options here. First, we dump the fixed-rate second trust and replace it with an i/o program tied to the Prime Rate. Let's use an interest rate of prime plus one percent. Since Prime Rate is currently at four percent, your rate would be five percent. Borrowing $30,000, the i/o payment drops to $125 per month.

Now let's examine an interest-only ARM for the first trust. I'll use a 5/1 ARM for starters. This program carries a fixed rate for the first five years and adjusts annually thereafter. You might find a 5/1 ARM with a start rate of 5.25 percent. The i/o payment on a loan amount of $240,000 is $1,050.

The combined interest-only payment is now $1,175 -- only $97 higher than your target payment.

Now let's look at a monthly ARM. You should find an ARM tied to the London Interbank Offering Rate, or LIBOR, with a rate as low as 3.25 percent. The interest-only payment with such a low rate on a $240,000 loan is a rock-bottom $650 per month.

Combine the $125 second trust payment and the $650 first trust payment and we have a total interest payment of only $775 -- $303 less than your target payment.

The analysis shows that you are indeed, able to purchase your $300,000 home and temporarily keep your payments at or under your comfort level. But understand the pitfalls. The rate on the 5/1 ARM can increase after five years. We don't know where rates will be when the time comes, and you may wind up paying a significantly higher rate.

The same goes for the monthly ARM, except that it can change monthly.

What I've preached a thousand times in this column is that interest rates are dynamic. They are currently positioned to rise over the next several months. But what goes up usually comes back down eventually. As long as you understand that taking out an ARM means that you will be subject to interest rate fluctuations in the future, you will be able to make the optimal decision.

Published: May 27, 2004

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.