Lately, the loan companies around here have been pushing something called an “interest-only mortgage.” I don’t own property, nor will I be buying any in the near future, but I’ve got to wonder what’s going on here. One of the big companies (Rock Financial) is advertizing a “thirty year interest-only mortgage.” Does this mean that you’ll make loan payments for 30 years, and still not have a penny of equity in your house? After the loan period expires, what happens to all of that principle that hasn’t been payed? Do you get hit with the mother of all balloon payments? Am I missing something here, or this some kind of con job?
Here is a thread I started earlier on the same subject.
It’s typically a 10-year Interest-Only “Option”, meaning you can make the minimum (interest-only) payments for the first 10 years, and at the end of that term, the loan is re-amortized over the remaining 20-years.
Not exactly a scam, but you probably don’t want to make the minimum payments all 10 years.
Remember, barring a pre-payment penalty (and even these are usually “soft” - meaning you can typically pay up to 20% of the principle balance in any given year, which is more than most people who need a mortgage can afford), you can really make any payment above and beyond the minimum PITI (Principle, Interest, Taxes, and Insurance) that you want.
An I/O option is good for individuals with flexible incomes - such as those with seasonal or commission-based income - who may be able to make a double or triple payment some months, but only the minimum payment during other months.
It really just gives you more options, but keep in mind that one of those “options” is to really screw yourself.
These are pretty common in the UK, and are known as “endowment mortgages”. At the time you take out the mortgage you also take out an “endowment policy” (similar to, and incorporating, life insurance) which will pay off the capital* at the end of the term - typically 25 years. Interest only is paid for the term of the mortgage.
If the mortgagee dies during the term of the mortgage, the policy pays off the capital at that point.
- At least, this is what has happened historically, although of late some endowment policies have performed badly, leading to a shortfall. Due to this endowment mortgages have become less popular
So it would be just like paying rent, but tax deductible?
Don’t forget the pivotal point that presumably your house will appreciate during these 30 years. If you’re buying property in Detroit (the non-nice parts) on a 30 year, interest-only note, then maybe someone else should be making your financial decisions for you! 
Not quite–principal payments aren’t the only source of home equity, there’s also appreciation…
Yes and over the 30 year span at 5% for a $100000 mortgage the “interest only for 10 years” option would cost you an extra $50/month over a regular 5%, 30 year mortgage.
That’s $50/month before taking the income tax deduction that is. If you itemize deductions and your top tax rate is 15% you would pay about $36 extra for the interest only option.
However, in the later years of the mortgage your itemized deduction total might be less than the standard deduction because the amount of interest is small so it gets a little hard to figure that far in advance.
Others have mentioned appreciation. In some cases this is true, in others not, so I wouldn’t spend the anticipated appreciation on a new car just yet.
Endowment mortgages are entirely different things. An interest only mortgage is simply that: you just pay the interest over the term and it’s up to you to find a way to repay the capital at the term. You can do this by periodic payment, endowment, pension, investment, or by selling the house for more than you paid for it.
In a rising market where you’re expecting to sell the house for a profit in a few years, an interest-only mortgage provides maximum leverage for you money. Of course, should the market fall, you’re going to make a loss, and you’ll need to cover that loss.
It’s not a scam, per se. But it’s an offering that may harm or benefit the consumer, depending on his status.
Remember that in any loan, mortgage funding, or installment purchase, what you’re actually buying is time. If you’re willing to give me $13,600 in exchange for $10,000 right now, you’re a fool. But if we work it out where I give you $10,000 right now and you give me $200 for the next 68 months, that’s a deal you may find quite palatable. If I need a car and don’t have $19,999 to pay for it, but can afford to pay $26,000 for it in five years of installment payments, that’s a deal everyone can live with.
In a normal mortgage, part – the proportions vary in every mortgage and even in every payment on a mortgage – goes to cover accrued interest and part goes to reduce the principal P. So in the course of a year you have paid interest due of X and reduced the principal owed by Y. And in the following year your interest is based on the remaining principal, P-Y, which means that for identical payment values, your interest cost is lower and more goes to reduce principal, further lowering your new principal, etc. (Actually, it’s even more complex than that, owing to the fact that each payment reduces principal, but that abstraction will paint a clearer picture.)
In an interest-only mortgage, your principal owed remains intact for the duration of the interest-only period (which may be the length of the mortgage or the first ten years, as noted). This means your payments are lower, but you accrue no equity from reduction of the principal (although the property may appreciate in value, building you some equity that way). The bank/mortgage company benefits because every penny you pay is interest; they retain the same equity in the property as when you started. But you may benefit if working an interest-only mortgage enables you to afford what you need or want but could not afford standard-mortgage payments on until your own income climbs (and you have a reasonable expectation that it will), or so that you can take the money saved from the difference in payments between standard and interest-only and invest it to make more than you would make in accrued equity.
So a gamble is involved, but one in which you can assess the benefits and costs quite well.
As I told my wife when we built our house on a 30 year mortgage, “We’ve only owned the house a year and we’ve already paid of $46.21 of the principal.”
From my research, IO loans work well if the following conditions are met:
a. The house value is expected to appreciate.
b. You plan to move before the Interest Only portion of the mortgage time is up, preferably within 5 years.
We plan to close on a house in a few weeks, March 11. The seller dropped the price because about $15,000 last week because she is closing on her NEW house in 9 days, and the new purchase was contingent on the sale of the existing home.
My company will VERY likely relocate me within the next three years.
We are using an IO Mortgage, because it works for our particular situation. We qualified for a conventional style loan as well, but the equity obtained in the first three or four years of owning was not going to be appreciably more attractive than the smaller mortgage payment.
If we planned to live here ten years, we would not have gone this route.
Pre-payment penalties are often very attractive in your situation as well, as they can lower your rate significantly, and are usually waived on the sale of the home after a short amount of time (typically 1 year.) Ask your Loan Officer.