Interest Only Mortgages?

Factual Questions
1

The local news station I listen to has been repeatedly playing commercials from several different mortgage companies hawking “interest only” mortgages. This is where you pay only the interest on the mortgage, and so lower your monthly payments significantly.

Maybe I’m too suspicious (the guys on the commercials sound like car dealers), but is this really that good of a deal? I know with my mortgage in the early years I pay a lot more in interest and less in principle, so if I pay only the interest, I don’t save that awfully much initially.

I guess if your house appreciates, such a mortgage would work out when you go to sell. But if it doesn’t, or if you take out extra money – like the ads promote (“Take an extra $100,000 to pay off your debts!”) – couldn’t you end up not being able to sell your house for enough to pay off the full principle?

2

Do they allow these loans for people who don’t have any equity in their home? Getting upside down on a mortgage would be fairly difficult if you made a significant down payment.

(Personally, I wouldn’t touch an interest-only mortgage with a 10-foot pole, unless I had to relocate and needed to reduce the payment while I was waiting for my place to sell, or something…)

3

The idea behind them, from what I’ve been able to gather, is for reasonably-high-income families that relocate regularly, and who prefer “owning” a mortgaged home to renting, to set up a mortgage where they do not pay higher mortgage payments in order to build up equity, but rather make payments that are effectively “renting” the property from the mortgage-holding bank for the period of time they’re at that location. The benefit to the bank, of course, is that it’s making a secured loan at good interest without the ongoing need to recalculate relative equity of the homeowner and the mortgage-holder.

In other words, you’re transferred from Houston to Raleigh, selling your house in Houston and paying off the mortgage. You expect to be in Raleigh three to five years, and then to be transferred on to Seattle or wherever. But you don’t want to rent a townhouse, you want a house on a cul-de-sac for your 3.5 children and 1.5 dogs (that’s where Halvsie went!). By ponying up the $20,000 settlement from the sale of your Houston house, you can afford a nice house – but by taking out an interest-only mortgage, you keep your payments down, and have only that $20,000 in equity when you move to Seattle in 2008, to repeat the process there.

4

It’s been promoted in the past as “buy now while the rates are low, you’ll earn more money in a few years and can put that towards the principle”.

Of course, when so many people only make the minimum payment on their credit cards they’re suprised to learn that they’ve “paid for years but still owe the same amount”.

I suspect much of the furniture and electronics in those houses are rent-to-own as well.

5

Part of the theory of these is that houses will appreciate with time. So, if you buy a house for $300,000 and just pay the principle, then in 5 years with huge appreciation the house is worth $500,000 and you have suddenly $200,000 in equity without having worked down the principle. When I looked at an interest only loan lately the interest was even less than normal market rates which is, I suppose, because it was calculatedly like a balloon or ARM. I know the interest jacked up later. So these are good if you believe that your income will increase AND that housing prices will rise or are at least not going to crash. If you have uncertain income or believe that there is a housing bubble in your market then you should stay the hell away. Generally speaking, of course.

6

A few links to some good interest-only mortgage resources.

http://money.cnn.com/2003/08/20/pf/yourhome/interestonlyloans/

7

The bottom line is that it’s an option worth considering if, and only if, 1)you intend to stay in your house for a few years and then sell and move on and 2)you expect the value of your house to increase in the meantime.

8

It’s no accident that the rise in popularity of interest-only mortgages has coincided with the unprecented rise in property values nationwide. Most people see it as a way to be able to afford a home at the high prices they command these days. The larger the numbers, the more money you can save on a monthly basis with interest only payments. But is it worth it in the long haul?

Let’s say the houses in the area you want to buy in cost 500,000. Somehow you have 100,000 to put down, but you still need to borrow 400,000. Let’s say the lowest interest rate you can get is fixed at 5% for 5 years. Your fully amortizing payments would be $2,147.29 per month, while an interest-only payment would be $1,666.67. Looking at it that way, you could save $480.62 a month for 5 years, a total savings of $28,837.20.

Now let’s say that at the end of 5 years, your house is worth a million dollars. If you had been making fully amortizing payments, your equity stake would have grown from $100,000 to $632,685.07. If you had been making interest only payments, your equity stake would only be $600,000. If you can afford to, it’s better to make fully amortizing payments.

However, if you can only afford the $1,667 a month, and you want to buy a house, interest only starts to look very attractive. Especially if you want to live in an area where prices are appreciating quickly.

One more point: a very savvy investor (if there is such a thing) could take the 480 a month they’re saving and invest it in stocks and/or bonds, or a business they’re starting, or maybe the mortgage on an investment property. In any of those cases, they might be able to get a better return than if they simply plowed it into the equity on their primary residence.

And yes, there aree 100% LTV interest-only loans in the marketplace.

9

I have an interest only loan.

I just bought my very first condo. It’s probably not going to be the place I live forever and ever. So assuming that I only stay in it for a couple of years, I wouldn’t have paid down much principle anyway. The difference in payment between a 30 year fixed and my interest only loan was several hundred dollars a month.

Now, interest only is not for everyone. You kind of have to be a smart investor. For example, if I decide I really like my condo, and I want to stay in it, after 5 years my payments are going to go WAY up. I will have 25 years to pay off my principle, rather than 30. If I’m not ready for that, I could be screwed.

But…in all likelihood, if I decide to stick around, I’ll end up refinancing. Hell, I may do it anyway, just to get a fixed interest rate if they continue to creep up.

So it’s a good way to get your foot in the door in the real estate market. However, I suspect that often times in reality it’s causing people to buy homes they really can’t afford.

10

One thing that I wondered about w/ I.O.M.'s.

If you make any payment even a dollar towards principal, your monthly payments after that has to go at least partly torwds principal since you no longer own the whole initial amount, so the interest you own has to be less.

This assumes your payments are fixed.
Is this correct, and if so then a interest only loan can be converted to a standard loan by making a single overpayment towards principal?

11

You can make any amount of principal payment you want in any month on an IOM but it doesn’t automatically convert your loan to a standard loan. It’s still the same IO loan.

12

The tutorial on the Mortgage Professor’s page (link above) discusses this to some extent.

Interest only is an option that you can exercise or not on a monthly basis during the interest only period of the mortgage. Your payment towards principal should reduce the interest payments that you make and possibly reduce the time it takes you to pay off the loan.