Recently, banks have been promoting “interest only loans”.
I was curious as to how they worked. I even wrote my own calculator http://www.1728.com/intonly.htm which was easy to do. (The math is quite simple).
However, at the end of that calculator I gave one example of an “interest only” loan as compared to a regular mortgage.
I just wanted to know if I am the only one that feels that an “interest only” loan is a waste of a person’s time and money.
I put this in GQ because I think it should have a definite answer.
Maybe my calculations are wrong and my findings about an interest only loan could be wrong. I’m sure the Dopers will give this question a rigorous analysis.
If you are in an area where real estate values are rapidly advancing then you could actually make money using a no interest loan. However, that is exactly why there is so much discussion about a “real-estate bubble”. If prices suddenly drop 10% or more then you have lost your bet.
Objection! “Calls for an opinion.”
Moved to IMHO from GQ.
samclem GQ moderator
An interest-only loan is okay, I guess, if you don’t mind a big balloon payment (the entire original loan amount IIRC) coming due at the end of it.
Really bad idea.
With rates as low as they are, if you still need an interest-only loan to qualify for something, you probably shouldn’t do it.
Interest-only loans have gotten incredibly popular in California in the last couple of years. I think they make sense if you’re buying property purely as an investment, and intend to make money solely based on it significantly increasing in value over a short period of time. In other words, two years ago. Without a time machine, or for a house you intend to live in for an indefinite or extended period of time, I think they’re a terrible idea. You get no equity, so you’re basically paying the bank twice as much to rent your house. And if interest rates increase, as they almost certainly will, you won’t be able to make your payment once the interest-only period ends.
I personally think interest-only loans are going to lead to a huge spike in foreclosures over the next 3-5 years and drive house prices way down all over California. The current situation is completely unsustainable.
I have one. I used it to come up with 15% of my downpayment, saving me the PMI payments. I justfied it thus: The money I use to pay the PMI goes down the drain without benefitting me. However, I get to deduct the interest paid on the interest-only loan (technically a 10-year ARM with no penalty for early payoff) and, as or if I pay down on the principle, I have that much equity in my house. If I’d mortgaged the whole thing, I’d be paying PMI and not getting anything in return.
The tricky part is to not pay only the interest. I add $300 a month on top of the interest to chip away at the principle. My 10-year loan should be paid off in three and a half and I will have deducted the interest paid the entire time. Also, by paying it off in 1/3 the time, I saved probably thousands, if not hundreds in interest as my principle was chipped away.
If you’re smarter than the loan, then yes, I think it’s worth it. If you play into what the lender wants you to do, which is make minimal interest only payments then flip the loan into something else when the balloon comes due, then you’re just the lender’s bitch. IMHO.
Wow a thread that already has two postings from moderators !!!
Dogzilla
Darned good posting.
I’ll have to write another example for my Interest Only calculator to show how it can work to your advantage.
As you mentioned, if you pay off a loan according to the method the lender wants, you are really putting yourself at a disadvantage. It reminds me of trying to pay off your MasterCard bill just by making the minimum payment.
Dogzilla
So what happens to the principal that’s due at the 10 year mark? You’ll have to refi, correct?
It depends very much on your circumstances. For a lot of people, they’re a bad idea.
I’ve been reading how, in some areas where housing prices are off the charts, IO has become so popular because otherwise people couldn’t afford to buy. That’s scary.
For some people, though, they can be a good deal. We are almost guaranteed to be relocating within the next 2-3 years; plus, the area we’re in is undervalued compared to the rest of the Atlanta metro area, so the value of our house is very likely to increase. So for our particular situation, IO made sense. We’re still taking on some risk with it, but it’s smallish.
NillyWilly
I was wondering about that too.
As I said, I wrote an “interest only loan” calculator http://www.1728.com/intonly.htm
and a short tutorial. Hmmmmmm, now that I think about this:
Dogzilla - what is the difference between your interest only loan and getting a regular mortgage in which you can pay in addition to the interest payment whatever amount of principal you want to reduce?
I have an interest only option on my mortgage and felt it was worthwhile for another reason. In the past two years, I’ve experienced a lot of job uncertainty, including being laid off from one company and taking a 15% salary cut at my current employer. The current economic “recovery” has largely been jobless in my field, and I really don’t see it ever returning to its former glory. With that in mind, the interest only option gives me a little more cushion to weather out a potential future career bump, or at least stave off foreclosure a bit longer.
Even with the interest only option available, I still make regular principal & interest payments (as if based on standard 30 year amortization) so I’m not really penalizing myself in the present. My mortgage broker assured me I wasn’t paying a higher rate for this option, although some of my closing costs may have been slightly higher because of it.
Weren’t interest-only mortgages the norm before the Depression? From what I remember of my high school history lessons, millions of people couldn’t afford the balloon payment at the end of the loan term, and banks were unwilling to carry the loans forward, so foreclosures were widespread.
The difference between Depression-era loans and those of today, IIRC, is that initial down payments used to be much higher.
Well I guess I’m not understanding the interest only loan concept properly.
Where does this balloon payment come from?
From what I understand. . .
We both have 30 year loans. My is normal. Yours is interest only.
Normal case: I take out a 30 year mortgage on my house and I pay Principal and Interest for 30 years. I have a nice interest rate and a payment I’m comfortable with.
Interest only case: You pay interest only for 5 years. 5 years from now, you are paying off the principal and the interest on the same value but over a 25 year period because you’ve only paid interest for the last 5 years.
If the interest rates are higher in 5 years (and sometimes that kind of thing is written into the interest only) you’re going to have higher payments and you’re still not going to have any equity.
In general. . .there’s something that upsets my stomach about taking out a loan and not paying it off, not having it “amortize” (I think I’m using that word correctly). I mean, that’s the point of a loan. . .to pay something off. Interest is the cost of doing business. . .it shouldn’t be the business.
I understand that IOL’s are the only way for people to get into the market. And, they would have been PERFECT for lots of people 5 or 10 years ago. When people are doing that IN LARGE NUMBERS like they are now, it’s hard to conceive that the real estate has anywhere else to go. It’s things like IOLs that have helped drive the boom. Can they sustain it? Can another “loan product” come along to prime the pump again?
Only time will tell.
One other thing. . .
Let’s say I just got a loan. My payments each month are, $1000. THAT’S what stays constant.
Right now, $750 of that is interest, $250 is principal. Next year, though, $700 of that is interest, $300 is principal. The year after, $600/$400. I’m paying interest on less and less principal.
In 5 years of paying interest only, you’re only going to be in the position of paying $750 in interest, $250 in principal.
Basically, avoiding PMI is no reason to do interest only. Of course the taxes can be written off, but you’re getting no equity. A lender will tell you, “oh, the true investment value of your house comes from appreciation” but IT JUST FEELS prudent to build equity in the property the old fashion way. . .by paying off the loan.
Trunk don’t like the interest only.
Neither does Michelle Singletary, a Washington Post columnist (link may require free registration).
To me, they seem like a Very Bad Idea in nearly every situation. If the only way you could afford to buy a home is by doing this, then it’s an indication that you can’t afford to buy the home. Of course, you have to weigh your own circumstances, your plans for staying in the home long-term, likely changes in your situation (e.g. finishing school and going to work full time), and worst-case scenarios for a few years out - like can you afford the larger payments.
Are these loans interest-only for 30 years? or just for the first few years? What will happen to their interest rate? Do they require a balloon payment or do they automatically convert to a fully-amortized loan at the then-current market rate? To many “what-ifs” for my taste.
Refinance what? I’ve paid it down. That extra $300 a month I’m sending applies to the principal. I’ve 2/3 paid off the ENTIRE loan and I’m only 2 years into it. There won’t be a dime due at the 10-year mark because I paid off the principal 7 years ago and the thing doesn’t even exist. And, I’ll have 20% equity in my house. (30% at least, actually, by then)
Then I would be financing 95% of the cost of the home on one loan and would be required to pay PMI. This way, I put up 5% cash out of my pocket, took the home equity LOC (the 10 year ARM that’s two-thirds gone already) and my primary mortgage is 80% of the price of the house, ergo, no PMI required.
Now the Wells Fargo guy who set this up for me tried to talk me into making interest-only payments and then refi at 10 years. “Ehhh interest rates are low and you can use that money for something else.”
:wally
Like a shiny, new bauble? I didn’t think so. I knew the rates were so low (two years ago), they wouldn’t stay that way for long. I took that loan at 4.25% (I have outstanding credit). The rate is now up to 7% (which still isn’t bad, but has steadily crept up, just as I predicted), but my interest-only payment due hasn’t increased because I’ve reduced the principal so significantly.
I think this loan could become a real headache if interest rates shoot up and suddenly, I’m looking at 10-12% or higher. That’s when I refi.
Sounds like you’ve got a combination of two loans then - one primary, and the second one (The 10-year “interest only”) which you got in lieu of paying PMI? while the primary one is a more traditional amortized mortgage?
Sounds like a really smart move to me. That secondary loan’s interest is fully deductible (unlike PMI) and you’re really handling it in an intelligent way by paying it off a lot faster. Very different from the kind of situation that worries the financial planning folks - someone who can only afford a house by going interest-only.