Take an IO to Pay Down a Second Mortgage Faster?

March 6, 2006

If you take a combination first and second mortgage, wouldn’t it save money if you made the first mortgage IO and used the cash flow saving to pay down the higher-rate second?

If the rate on the first was the same with and without IO, you would indeed save money by taking the IO on the first and applying the payment saving to a more rapid reduction of the balance on a higher-rate second. Assuming the rate on the first is higher with than without the IO, however, which is the case, the savings from paying down the high rate second mortgage tend to be offset by the higher interest payments on the first. Where you come out is not clear.

To get a handle on it, I constructed a little spreadsheet. The spreadsheet showed that in the short-term, the strategy of using the cash flow savings on an IO to pay down the balance on a higher-rate second mortgage was a sure loser under any reasonable assumptions. You had to stick with it for some years before you could possibly end up ahead.

Further, even over a long period, it will only work if you pay a rate no more than .125% higher for the IO as opposed to the non-IO version of the first mortgage, and only if the second mortgage rate is at least 2.5% higher than the rate on the IO first. These conditions are not likely to arise very often.

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