Why Get an Interest Only Mortgage?
Have you ever wondered why people choose interest only mortgages? Let’s break it down!
#Mortgage #InterestOnly #Finance #Housing
Understanding Interest Only Mortgages
Scenario Explained
Why might someone opt for an interest-only mortgage?
– Allows for lower initial monthly payments
– Can be beneficial for short-term ownership
– Potential for investment purposes
What’s the catch?
– Balloon payment at end of term
– Risk of property value depreciation
– Limited equity buildup
Curiosity piqued? Learn more about the ins and outs of interest only mortgages and whether they could be a suitable option for you!
If you believe market growth will outpace what it costs you in interest, it can be more efficient to use the money you would have paid towards principal and invest that in the stock market.
After 30 years you’d still have the full principal left on the mortgage, but that’s a long enough timespan that the market should average decent returns and you should be able to sell your investments you made with the difference and pay the entire mortgage off if you wanted to.
Because it is cheaper than renting and you only plan on being in it for a few years before refinancing or moving and thus will save money based on loan origination costs.
Interest-only mortgages are for when your plan is to not live in a house for very long, and you also expect the house will greatly increase in value during that short time. (I think these were especially popular in the early 2000s.) I had a colleague who bought a townhouse for $200,000. He planned to live there for only a few years and then sell it for $300,000. His profit would be $100,000 minus what he paid in interest on the mortgage. His opinion was that an interest-only mortgage was a no-brainer.
Of course, the risk is that if you end up living in the house for a long time, or, if the house doesn’t increase in value, then an interest-only mortgage is a terrible idea. I would never take that risk, personally, and I don’t know how it ended up working out for my colleague.
An interest only mortgage have lower monthly payments, as you only pay the interest and no downpayment. In those 20 years you would have saved as much as the entire mortgage in cheaper monthly payments. You can invest these savings and on average end up with more money then if you made downpayments on your mortgage. The issue is that you are taking a bit of a risk. If the stock market drops at the wrong time you may lose your home.
I think of it like paying to lock in the price. Say you find a property for $500k that you want to buy, but you cannot pay for it yet. For a relatively low monthly fee, you can lock that price at $500k and use the property as your own. As long as you keep paying that fee, the price stays $500k should you chose to pay for it later. In 5 years, every other place nearby costs $750k, but you can still buy it at the price you locked-in ($500k) if you want.
Interest only mortgages were intended for developers and people doing housing renovations to flip the house. Basically you’re trying to minimize how much cash you tie up in the property because you’re using that cash to improve the property. In theory, you sell it before this becomes an issue.
There’s nothing binding them to just that use case, and so people started making stupid choices. But that was their original purpose.
Some people may find well thought out situations where they make sense(e.g. if rates are low, lock in the rate now even if you can’t afford to cover the principal as well) but those are very specific situations and should only be done by people who actually know what they’re doing, not by people who just read a blog about it on the internet.
Just to add to the other answers it’s worth noting that if you have *any* investment vehicle available where the return will be greater than the rate of the mortgage you would be better off repaying the principal of the mortgage at the end of the term.
So if your mortgage rate is ~2-3% and a simple index fund averages 8% you’ll have more money after 25 years if you take out an interest only mortgage and put a bit of money into the index fund instead. At the end of the term you take enough out of the index fund to repay your mortgage principal and you’ll have some money left over even if you paid the equivalent amount in total to a repayment mortgage.
The issue of course is risk so this isn’t usually a good idea for residential mortgages. Not sure how it is in other countries but in the UK we have a bit of a looming crisis from self-certified interest only mortgages where the terms are coming up to expiry with no repayment vehicles, or repayment vehicles that failed horribly.
People are suddenly finding themselves hitting retirement with a lender asking for an appreciable fraction of their property value, especially in areas where said values haven’t increased as much.
If the rate’s locked in then you have WAY more stability on housing costs during those years than you would while renting.
Assuming the interest is competitive with or beats rent, which it generally will be with ever rising rents, then you would use that time to build up your down-payment to refinance into a traditional mortgage. Or sell when you need to relocate.
Also provides a way to live somewhere just for a few years when the rent market is tight or exorbitant.
Big thing you seem to be missing (at least in terms of how you asked your question) is that after 20 years, you’ve had a place to live for 20 years, which is a valuable asset in itself.
It may be cheaper than renting the equivalent and you don’t plan to be there very long. Also if you think the value might go up significantly over a few years you could make money off of it. This is especially true if you are flipping the house.
You are never obligated to make *only* the minimum payment. This is the key thing that you are missing. I think top level comments get removed if they dont have more text than a few sentences. So hear is some additional text to escape our AI overlords.
They’re definitely a niche product… but here are a few scenarios.
– You’re a flipper who will be buying the home to remodel and sell, and want to keep carrying costs to a minimum. You plan to own for 6 months or a year and all your gains will be due to the work you put into the house, not paying down the mortgage.
– You’re buying a starter home/condo and think prices will keep going up, but that you don’t plan to stick around very long. Since most of the early year mortgage payments are going to interest anyhow, you go interest only, invest the difference and just hope to profit from value appreciation when you sell in a couple years.
It works very well for investment properties you want the rent to pay you an income not pay off the mortgage so interest only works. Like any business you want your overheads as low as possible.
This can make sense if you’re buying a house primarily as an investment, and you don’t plan to own it very long. You are betting that housing prices will rise rapidly, and you may be planning on being able to add lots of value to the home via affordable renovations (house flipping).
For example, if you expect the price of the home to rise by 10-20% over a year or two, and your interest rate is only 3% (assuming you have a time machine), the savings on payments will make up for the fact that you aren’t paying down the principal (assuming your prediction pans out).
The lower payments could also enable you to speculate on multiple homes at the same time. This increases your exposure to risk, but also multiplies your potential profit.
From an economic perspective you should always invest as much as possible to make your money grow. But you do want to live in a house so you take out a mortgage. But if the interest is lower than what you expect to earn from your money investing, you would rather spend as much money as possible investing and as little as possible paying back.
In recent years it was possible to get mortgages with 0.5% interest locked for 30 years. In that case it makes perfect sense to focus on investing your money, rather than “tying them up in bricks”. When the 30 years are up, you pay out the mortgage with the money you earned investing and keep the rest.
When interest rates are good, interest only is a much better choice. The S&P500 has averaged ~10% returns since 1928…..when interest rates were 3-4%, interest-only was a no-brainer. Nowadays it’s less clear (since you pay taxes on your market gains and in some cases can deduct part of your mortgage interest, etc).
To add to some of the points already made, IO loans are a popular option with investors as well.
Say you are looking to buy an investment property and rent it out. The purchase price is $100k and you secure it with an IO loan. You can set rent for your tenants to cover the IO payment or even more if you want. 5 years down the line the value of the home is up 50% and you sell for $150k. You just made $50k while someone else made all the payments.
Oversimplification as there are more costs to ownership, down payments, and all that fun stuff but that’s a basic breakdown of why you might get an IO loan on an investment property.
To add to others, these were more popular when rates were lower and it allowed people to get into homes they otherwise would not have been able to afford with a conventional mortgage from both a down payment and monthly payment perspective. Many interest only loans didn’t require 20% down.
One reason is if you are expecting a huge change in your salary in the (relatively) near future – such as a doctor doing his residency. He might be making average money for a few years but can very realistically expect his salary to triple or quadruple after that point.
Well, that is like paying rent when your landlord is the bank (in the US with their weird give-back-keys-rule even more so) and speculating on the housing prices moving in your favour.
You are missing one important thing: inflation.
Every dollar you pay on the mortgage principle today will be worth less tomorrow. You can pay off a 300.000 dollar mortgage over 30 years, but by the end of it that 300.000 dollars might be the price of a midsize family van instead of a house.
Obviously, not paying down the principle has a cost too since the interest stays high, but it could be worth calculating which approach is best financially.
It used to be very beneficial in The Netherlands, where the paid interest on your mortgage could be deducted from your income. A high mortgage the entire 30 years meant the most tax deduction. It was normally combined with a savings account, which would, in those same 30 years, save up the same amount of the mortgage.
Sadly, this construction is now not allowed any more.
If your scenario would still exist, it would definitely be valuable, even today. A mortgage of 200.000 now is NOT the same amount as 200.000 in 30 years, simply due to inflation. If inlfation is a not-impossible 3% for 30 years, that 200.000 would have to be more than 470.000 to have the same value. So, your mortgage effectively has shrunk by more than 50% in actual value!
You can always contribute more than the interest payment to pay down your principal each month. Any extra dollar you pay goes to the principal. I think that’s fairly normal. But if things ever get tight or if you lose your job or something, you’ll only have to worry about paying the interest until you restabilize.
Often people in jobs like sales will take an interest only loan because their income can vary so much month to month. When they have a great month they’ll put a lot down toward the principal.
I had a friend who exclusively did this. They bet the house would raise in value, wanted a low payment, wanted to live in a nicer house than they could otherwise afford and claimed that he liked changing homes every 3-5 years. Which for the life of me I cannot imagine being true, because I absolutely hate packing, moving and unpacking. Not to mention all the random crap that needs to be fixed when you buy a home.
When we did it in 06 just before the crash the loan person at wamu sold us on it like this “interest only for 1 year, then you refi next year when you have equity and you will get a far better rate.” And we bought into it. 312k interest only, then later that year the market crashed. We go back the following year to refinance and the house was only worth 285k based on comparables. So we got fucked on the timing on that. Had we did it a year earlier it 2kukd have been fine bit that market crash really fucked people in the end.
There is nothing preventing you from paying it off on the normal amortization schedule. So if you have variable/unpredictable income, you can get an interest only mortgage and treat the interest payments as your floor of how much you need to pay. In lean months or years you may be able to pay that much but not a regular mortgage’s monthly payment, in better months or years you can pay down the principal.
you get a lower payment, so easier to qualify for the loan
you are not paying down the loan, but you might expect the property to appreciate and sell in a short time
Basically you don’t want to miss out
If you have a separate brilliant scheme to pay off your house price and then some at the end of the payment term, but you need the money right now, then it makes sense. Such as, you are starting a business that you can sell in 20 years to make a ton of money, but the business doesn’t make you enough today to pay a full mortgage. Or you invest in the next bitcoin.
Americans move every 7 years. We buy a huge home; take the tax deduction and the equity without the “ownership” hang ups
It makes my rental properties cash flow better. Who cares about the principal?
It’s essentially like rent, but any increase in property value belongs to you. Of course, if the house goes down in value, you either have to be able to pay to sell it, or you’re stuck there. With a traditional mortgage, even if the home price stayed level, you’d accrue equity over time, here you don’t.
If the home price goes up a lot and you move within a couple years, you’ve come out ahead. If the home price only goes up a little, or you’re there for many years, it’s probably not that great. If the home price goes down and/or you can’t move for whatever reason, it’s bad. But, so long as you can service the mortgage, you won’t be homeless. If it’s variable rate, then you could eventually wind up with a *more* expensive mortgage than if you had gotten a traditional mortgage in the first place.
So, it’s a risk, but there are certain situations it could work out.
Selling a house is expensive. If you can’t quite afford the home you need right now, and your income is expected to go up, and the interest is less than a rent payment, you can buy the house now, make bigger payments later, live in it longer, and still come out ahead.
It’s a very narrow use case, but a lot of people only deal in “what payment can I make each month?” If they can have something and pay for it forever, that’s better to them than not having it.
I’ve done interest only loans because I needed them for business growth. Anything to keep the payment low until income picked up. I used to build houses. I knew it was going to sell, but I needed money to finish it. The lower the payment the better. Once the house sold, it all got paid off at one.
I’d rather have an interest only mortgage, than 26+% credit card debt. You do what you need to do.
Sometimes people make stupid decisions though. Not everybody understands interest.
Planet Money, possibly The Indicator just did a podcast on car payments. Somebody put $50,000 down on a new $80,000 Escalade, made $30,000 in payments, and owed $75,000. Make that make sense.
Interest only loans are typically used by house flippers, they’re advantageous for a couple reasons. First you only have to pay the interest, so if you can buy a $200,000 house and fix and flip it for $350,000 in 1 year, then with an interest only loan at 3%-5% you would only have to pay $6,000-$10,000 for that loan (with the house generally as collateral) and this interest doesn’t compound, so they know they only need to pay $500-$833 per month. This allows a house flipper to significantly minimize their risk. Furthermore, since they don’t own it for a full year, they often don’t have to pay property taxes on the property, (and potentially don’t have to pay much taxes on the loan). Additionally, being able to buy it in cash from a bank (and not using realtors) means they might not need to pay closing costs (which are usually a percentage of the sale).
The downside is that the principle needs to be fully paid off by that small timeframe (~1-5 years).
And is a LOT more expensive per year than a traditional mortgage, since paying down the principle doesn’t reduce the interest amount.
TLDR; house flippers can get a loan for a house very cheaply usually with the house as collateral. This lets them not have to pay a lot of things that would cut into their profit such as; principle payments, property taxes, or sometimes even closing fees, and would allow a house flipper to still make a profit even if they only increased the house value by ~10%-15%.
The big downside is that paying down the principle doesn’t reduce the interest payments, (if you paid it off next year or tomorrow you’d still owe $10,000+ principle).