I’ve been seeing and hearing a lot of ads recently for these loans. Lots of times they don’t even mention that they are interest only. For example, one radio commercial running locally is advertising mortgages at 3.5% with a monthly payment of only $292.00 for each $100,000 borrowed. Sounds too good to be true, doesn’t it? Doing the math, $292 per month will pay only the interest, with nothing going to principal.
Why do people sign up for loans like this? If they pay on this loan for 10 years, they’ll still owe $100,000 at the end. Are people just stupid and don’t realize what they’re getting into, or is there some reason that these loans can be a good thing?
Interest-only loans are good for people who want to do something else with the money they’d be paying for principal and can make a better return on it.
Or, they are good for people who plan to pay some principal each month but don’t want to be stuck with a fixed amount.
I myself am refinancing right now into an 3/1 interest-only loan. In my situation, I wanted to have the greatest amount of cash available to me after the refi so I wanted the lowest payments possible. I plan to use a few months of having that “extra” money (the difference between interest-only and what I used to pay) to pay off some other things; then I plan to pay principal each month anyway.
After the 3 years (by which time I’ll refi anyway, most likely) the interest-only payment goes to interest + principal, and jumps almost 50%. However, it will still $300 per month less than what I’m paying now.
I just wanted to point out that not only will it go to interest + principal, it will also go to current index + margin. Since there is no way to predict what the 1 year LIBOR will be three years from now, you could guess based on previous history. 3 years ago, it was about 3.75, and the typical margin on these loans is 2.25, so you can reasonably expect your new rate to be your existing rate + 2% or 6%, whichever is lower. Also, the remaining P and I loan payments will be amortized over 27 years instead of the standard 30, so that will increase your overall payment amount as well.
If you’ll shortly be getting a better job, or have paid off another load, but don’t have proof for a bank, it might make sense to just tide you over until you can afford to pay back more.
Sometimes people probably just feel overwhelmed, and hope something’ll come along and help them repay, when they can’t do without the money now, even though they can’t afford it either.
I think the answer is that MOST people don’t read the fine print. They see payments that are several hundred dollars below what they currently are paying, and they stop reading there.
But, there are some good uses for a loan like this. Several have been listed. Another example is some one that is building a new house, but already owns one. They can take out a short term, low payment loan to cover the purchase of land and construction, and the refinance as a standard mortgage once the house is completed and their old house is sold.
There are two elements to the appeal of these loans:
Upside #1 is that they generally have a lower initial interest rates than comparable fixed rate principal + interest loans. In this respect they are similar to adjustable rate P+I loans (ARMs).
potential downside to #1: Like all adjustable rate loans, at some point they are going to change their rate. How much is dependant on going rates at the time and the particulars of a given loan. As previously mentioned, loans are based on some index + some mark-up. Each loan also has some initial period during which the rate is fixed, and then some sort of cap on how much it can change each year. For example, a loan may be fixed for 5 years, then float at LIBOR rate + 2%, but can’t move more than 2% each time it adjusts. Bottom line: a 4.5% mortgage now could be a 10.5% mortgage 7 years from now.
Upside #2 is that because they are interest only, the total monthly payment is lower by the amount of principal you’re not paying. At some point, the IO loan will begin to amortize and you’ll have to pay both principal and interest. This can be useful if you expect to be making much more money 5 years from now than you are now.
potential downside to #2: You may not be able to afford suddenly having to pay principal on the loan when it transitions to an amortizing loan – especially since this point is usually coincident with the first adjustment to your loan. Suddenly an IO loan at 4.5% turns into a 25 year amortizing loan at 6.5%. Ouch.
For people who expect to move before the loan adjusts or expect to be making more money when the loan adjusts, these can work out well. Also, those who save/invest/pay off early the additional money (from not paying principal and having lower interest payments) they get from having an IO loan can come out ahead too. They’re also used by folks who don’t meet the debt to income rules to qualify for a bigger loan payment. These are the people who should definitely think long and hard before going with an IO loan.
I agonized over the decision when I bought my house last month. I ultimately went with a 30y fixed loan. Primarily I went with that over concern that interest rates would be significantly higher 5-10 years from now. But looking only at the next five years, I’d have saved a boatload of money by going IO. For my circumstances, and IMO, there was too much downside risk to going with the adjustable mortgage. Had I expected to move in the next 5 years, I would almost certainly have gone with an IO loan.
Another reason interest only loans may be a good deal is if you are planning on staying in a home for only a short period of time. I’ve been condo shopping lately, and know I’ll move again within the next five years. Take a look at an amortization table–there’s not much equity built in the first 5 years (or first 10 or 15 years, for that matter). If you’re not planning on staying long enough to pay off the loan, but rather living in the house for a few years and then moving, might as well either get a little more place, or be a little more cash rich. Your position when you sell won’t be too much different.
I’ve been wondering idly if an interest-only loan might be a viable option for my potential future situation – opinions welcome. We want to move to a different part of the Atlanta area in time for the beginning of the next school year. We don’t really want to move much before late spring of next year, because all of our target areas are farther from the private school our kids are in this year, and we’re committed to keeping them there the entire year, so even if we move we’ll still be driving out there every day. For a variety of reasons, most related to the fact that we have three children under the age of 7 including a 10-month-old and the fact that I travel about 75% of the time these days, it’s nearly impossible for us to declutter our house and neutralize it to the point that it shows as well as it might – we had the house on the market for 3 months last year without getting an offer, despite our best efforts, and the only negative feedback we got was related to things we can’t really change until we’re out of the house. So I was wondering if it would be feasible to find a new house in one of our target areas, buy with an interest-only loan, move, and then put the current house on the market after getting all of our stuff out. Making an interest-only payment on the new house and our current payment on our existing house would certainly be workable financially, whereas a full PITI payment on both wouldn’t be. Once the current house sells, we could then re-fi to a conventional mortgage on the new house.
Any reason this wouldn’t work out (aside from the obvious potential problem of it taking forever to sell the current house)?
Another possibility is to refi your current house to an IO, then buy the new place with whatever type of loan works best for you, then selling the old house. This way you lower your payments to a manageable level without forcing a refi on the new property. Many mortgage brokers will do a refi to an IO loan for zero cost to you.
I am about 4 days away from closing on a condo using a 5 year fixed IO loan. Like the Fifth Year, I figure this is just a starter home for me, and that was what prompted me to take this kind of loan.
Of course, I was also careful to not buy more than I could afford. If, 5 years down the road, I still live in the condo, and my payments go up, I expect that I will be able to make that higher payment without going broke.
It’s all about finding the right loan for YOU. And IO’s are certainly not for every situation.
The first 5 years or so of a fixed or variable interest loan pays far more interest than principal reduction.
Mortgage interest is totally deductible…principal is NOT…If you would normally pay 100.00 per mo. with 80.00 interest and 20.00 principal, it cost you 100.00 but only 80.00 is deductible…If you pay ALL interest at 80.00, you can take the 20.00 normally paid in principal and invest it wherever you like…if you do this wisely with the principal you would be able to pay down on the balance when the time is due and have plenty of pocket money…look what you saved in taxes alone.
