Interest only/Fixed Rate PART 2

Okay, this is part 2 of a previous thread that all of you helped me out on. My mortgage broker says he is trying to give me good advice by telling me to take out an interest only loan instead of a fixed rate. My credit is good, I have a good amount for a down payment, and have good income, so none of these things are factors in me getting a loan.

If my final loan amount is $475,000, and I take a loan out on the house, I have the following two options: Interest only at 5 years or 30 year fixed rates. Assuming that the rates are comparable, at the end of 5 years, where am I?

If at the end of 5 years, what would I owe on the 475,000 house. If I am correct, on the interest only I would still owe exactly $475,000 because I only paid the interest. But what would I owe on the 30 year fixed rate mortgage? Let’s assume I pay only the minimum monthly payments on both. If it is needed, let’s assume I have a 6.9% fixed rate for the 30 year mortgage.

I am usually good with numbers, but this is killing me. This broker even has my wife on his side. Can anyone help me?

According to this amortization schedule calculator, for a $475,000 loan at a fixed rate of 6.9%, after five years, you will have paid $30,601.72 in interest and $6,938.48 in principal, leaving a loan balance of $439,705.39. The interest is tax-deductible.

Not sure what you’re asking. At the end of 30 years on a 30 year mortgage, you’d owe nothing.

If you’re asking what you’d owe on a 30 year mortgage after 5 years, according to this mortgage calculator, you’d owe $446,083 on the house after 5 years with a $75K loan, 6.9% interest, and paying the minimum due every month.

IMO the only reason to take an interest-only loan is if you’re buying a house where you’re not sure you can make the monthly payments, and you want a lower monthly payment. You’ve indicated this is not the case for you. I think it makes more sense to take a fixed-rate 30 year mortgage.

Doh - that wasn’t clear. Those interest and principal amounts are for that fifth year, not all five years. The total interest amount for the first five years is in the neighborhood of $150,000, and the total principal around $33,000.

Additionally: At the end of 5 years, what happens? If the loan converts to an amortized loan for 25 years, then you’re amortizing that same mortgage over a shorter time, hence larger payments.

At 6.9% with a fully amortized 30 year mortgage, you’ll be paying 3,128.35 a month. In 5 years you’ll have paid down the mortgage so your new balance is 446,643. If you sell the house at that point, you’ve got nearly 30K more in your pocket than if you’d gone interest only (though that’s partly offset by the higher monthly payment). Your payment remains 3128.35 a month. At the end of 30 years, you’ll have paid 1,126,206.

At 6.9% with an interest-only 30-year mortgage that converts to an amortized mortgage in 5 years: Your interest-only payment is 2,731.35. That’s a savings of nearly 400 a month. Total payments in those 5 years, 163,875. At 5 years, I’m assuming it then amortizes over 25 years. Your new payment would be 3,326.96 at least (probably more, I assume the rate would also adjust at that point to some version of the market rate). If it doesn’t adjust, you’d pay a total of 998,088 for the remaining 25 years. Or a total of 1,161,963. Not dramatically more than the 1,126,206.

If the remaining 25 years adjusted to a rate of 7.9%, for example, your new payment would be 3634.72, you’d pay 1,090,414 for the 25 years, for a total 30 year cost of 1,278,039.

Basically, you have to look at the various terms of your proposed mortgage. If you’re only expecting to stay in the house for a few years, the interest-only might well be worth it. If you’re expecting to stay longer, then the balance might change.

What would you do with the monthly cost savings? If you’ll save, or at least invest it, that’s good. If you’d be using it to pay down existing other debt (student loan, CC, car loan), that’s OK also. If the difference in payment is the only way you could afford the house (not the case, if I read your OP correctly) then I wouldn’t advise buying the house at all.

This might be another thread, but can anyone possibly predict what the interest rate adjustment will be five years from now? Are there any financial gurus who, say, 5 years ago said the rates would be what they are now? Maybe this will help.

No. Anyone who could actually do this correctly would be the richest person in the world. And there would be a significant gap between them and number two. 3 years ago we had record low interest rates. Everyone and their mother refinanced, because how long could it last? The answer is apparently about 3 years.

If you plan to spend a great deal of time in the house go for the long term fixed. If you don’t then go with some shorter term/lower expenditure mortgage vehicle, be it interest only, an ARM, or a really maxed out credit card (Free money, if you roll it over before the grace period ends.)

If you plan to do short term than consider your market, the condition of the house, the newness of the house, the location of the house etc. to examine how realistic the rollover is. That is definitely a whole other thread.

The nice thing about fixed rate is that you have control over the loan. If you can afford it in your current situation there is an excellent chance you can afford it in the future. If rates go up you don’t care. If they go down you refi and take advantage of it. I generally gamble with what I can afford to lose, and the house does not fall under that umbrella.

On previewing I probably could have written this so that I don’t come across as a know it all santimonius prick. I apologize for my tone.

FYI - Motley Fool (www.fool.com) has some articles about interest-only mortgages; you have to register but it’s free. Not surprisingly, they don’t seem to love them.

I’m not sure if you’re aware of this detail (it was left out of the OP), but it’s not really a “5 year interest only”.

If I’m reading you right (and I remember correctly from when I was going through this), that means that your interest rate will be “locked in” for five years. After that, the rate will adjust based on some type of index (what that index is will vary from bank to bank or loan to loan). An interest only loan still has a duration (I think it’s almost always 30 years) at the end of which it must be paid off. You could pay extra every month, or only pay interest for 358 months, then cut the bank a check for $475,000 at the end (ok, that might be extreme, I haven’t actually seen an interest-only contract, so there may be additional limitations).

Here’s a couple hypothetical numbers that I got from an online mortgage calculator. I think that IO loans typically have slightly lower interest rates, so let’s say your choices are a 6.9% fixed and a 6.5% IO.

[ul]
[li]6.9% Fixed: monthly payment of $3128.35, around $400 goes to principal each month (with the amount increasing as the principal is paid down), after 5 years the remaining loan balance is $446,643, giving you $28,357 in equity[/li][li]6.9% IO: monthly payment of $2,731.25, nothing goes to principal, after 5 years the remaining loan balance is still $475,000.[/li][li]6.5% IO: monthly payment of $2,572.92. If you paid the $3128.35 per month you would’ve been paying with the 6.9% fixed, after 5 years your balance will be around $435,745.10, giving you $39,254.90 in equity. {note: due to differences in interest calculations with IO vs. fixed, this is likely inaccurate. I used a fixed rate calculator with 6.5% rate and extra payment bringing total monthly to $3,128.35. You’ll probably actually have more equity than that}[/li][/ul]

IMO, the key to playing the interest only game is what you do with that extra $400 / $550 a month that you’re not required to pay to the mortgage company.
[ul]
[li]If you need it to pay for necessities (not counting the mortgage itself), then you’re likely getting into a house that’s over your budget. A downturn in the housing market, an increase in interest rates (or worse: both) could potentially put you into some serious hurt. Being upside down on a mortgage (owing more to the bank than the property is worth) is not something you want to get into.[/li][li]Dumping the extra money into the mortgage might be a good plan if the interest-only has a lower rate than the fixed (as shown by the extra equity in the third bullet above). But once you get past the lock-in period, your rate is at the whims of the market. There are limits placed on the bank about what indexes can be used, how much they can change the rate, and how often, so you do have some protection from wild variations. [/li][li]Investing the money. If you’re good with managing your money, this might actually work. Even a simple money market account (at my bank I can get one at 2.2%) will net you roughly $35,000 (that was an after-tax calculation, so it’ll depend on your tax bracket) with a $550 monthly deposit for five years. With other investment options (CDs, bonds, mutual funds, playing the stock market) it may be possible to grow that money faster than a fixed rate mortgage would’ve been paid down. Again, once you get past the lock-in period, the mortgage payment will change, and there’s the risk of investment (which will vary depending on what investment option you use).[/li][/ul]

Note: I am not a mortgage broker, realtor, banker, or financial advisor. I just like to play with numbers, and went through a similar evaluation for myself last year. Given my budget, risk comfort, guesses on future interest rates, and time I expect to keep this house, I went with a 30 year fixed.

sigh. And after all that, I re-read through the previous posts again and realized I’ve basically duplicated what Mama Zappa wrote.