Interest only or fixed rate?

Factual Questions
1

I am in the process of moving to a bigger house and was talking to the mortgage broker. He is steadily trying to convince me to go with an interest only mortgage versus a fixed-rate. I know there are benefits to both, but am worried that if I take an interest only loan, I will be in a ‘bad place’ when it comes time to refinance.

Does anyone have experience in this?

What are the benefits of taking an interest-only loan? With the rising interest rates set forth by the Federal Reserve, wouldn’t the risk outweigh the benefits?

Does the mortgage broker make more money on an interest only loan over a conventional fixed-rate mortgage?

Also, off the subject, how do I ‘quote’ someone who is responding to this?

2

Just to state the obvious: With an interest only loan you never lower your principal. Is that good or bad? Hard to say. It depends on what you think will happen to the value of the house.

The big difference between an interest only loan and a regular mortgage is what you do with the money that isn’t going to the principal. With a tradtional mortgage you are essentially investing the principal portion in your house. Also, by paying down the principal each month you lower your interest you owe the next month and therefore have more money to pay into the principal.

Typically an interest only loan has a lower interest rate but, as you said, it is variable and runs the risk of rising over time. However, there are usually limits on how much it can rise so you should be at least somewhat covered.

If the house depreciates over time instead of appreciating, then when you go to sell it you will really see the difference between an interest only and traditional mortgage. You will still owe whatever you borrowed in an interest only loan, and if the house is now worth less than you paid for it, you’ll need to come up with the difference. With a traditional mortgage, at least some of the difference will be covered by the payments you were making. It might not cover all of it, though.

The short story is this: An interest only loan has the benefit of a typically lower payment and interest rate. A traditional mortgage has the benefit of you lowering your interest payments every month and owning more and more equity in the house over time.

When I looked at an interest only loan vs. a traditional mortgage I decided I’d rather just invest the money in the house and went with a traditional mortgage.

I don’t think you need to worry about what the mortgage broker is making off one vs. the other. Look at what you benefit from on one vs. the other. This might include fees, confidence, security, etc. If he makes an extra $1,000 because he sold you an interest only loan, that really isn’t a big deal as long as it was the right decision for you.

Just make sure you read all the fine print and know exactly what you are getting into. An interest only loan may have a balloon payment associated with it.
to quote someone, use the quote tags:

{quote=cmosdes}whatever you are quoting{/quote}.

Just replace the {} with and you are all set.

3

Welcome to the SDMB, Lance.

You have a very reasonable concern. There were a lot of interest only loans sold in the Bay Area, I believe to make the monthly payments more affordable for those wishing to buy a house at the very edge of affordability.

We’ve had adjustable rate mortgages, back a long time ago when rates were high and heading down. Today we have a fixed rate. You should realize that fixed rate mortgages allow you to refinance anyway. It does cost, but it is worthwhile if rates drop, and you are not forced into it.

As I said, lower monthly payments. If you planned to move before or close to the time of refinancing, it might be a good deal. Can you afford a fixed rate? If so, you should assses what you feel the probability of the interest only rate going higher than the fixed rate for yourself.

You should know that I’m loan averse, and have to prevent myself from paying off my not all that big mortgage, which I’m getting an excellent tax break on. I don’t like interest only loans because you’re not paying off the principal, even though I’m well aware that the amount you pay in the early years is trivial.

That I don’t know. It might depend on the incentives from the mortgage company. In the Bay Area, the mortgage ads have changed from those pushing interest only loans to those pushing fixed rate loans. Some of them seem to be saying “know the interest only loan we sold you a while back? Well, sucker, it’s time to switch to a fixed loan or you’ll be in trouble.”

When you hit the reply button at the end of a post (like this one) the text of the previous one will automatically be put in quote tags, which you can see. You can put them in manually around the text you are replying to (like I’m doing) or highlight a portion of text and click on the rightmost icon above the reply box. You can click on preview post after you’re done to see if you’ve done everything correctly.

4

Congratulations on looking for a bigger house I hope that you’re successful in finding your new dream house. Regarding the pressure from the mortgage lender pushing you toward an interest only mortgage, there are two probable explainations for this.

1)He gets a perk for selling the interest only mortgage, which is possible but not nearly as likely as…

  1. He doesn’t believe you’ll qualify or be able to support the fixed rate mortgage. The difference between fixed rate and interest payments can be several hundred dollars a month, which could be a problem if you were on a tight budget, but usually isn’t horribly significant. This is especially true with the new 40 and 50 year mortgages that have become available.

If you are looking to refinance in the next few years it probably won’t make a big difference one way or another, however I can only think of very few situations where I would reccommend an interest only mortgage over a fixed rate one.

A small nitpik is that while Home Equity rates are commonly tied to the prime rate established by the Fed, interest rates on original mortgages typically are not. That being said rates are slowly rising so you would probably be better off from a rate standpoint by going with a fixed rate loan.

What I would be most concerned about is the “housing bubble” I don’t know where you’re from, but the possibility exsists that housing prices could fall dramatically in your area. If you need to sell shortly after this happens you could find yourself upside down on your mortgage. This would happen with either fixed rate or interest only, however with the fixed rate you’ll have reduced the principal a bit to help soften the blow.

The worst case scenario would be to take the interest only mortgage, have interest rates rise and housing prices fall. The higher monthly payment could force you to sell at a bad time and you could end up very deep in debt. At least with the fixed rate mortgage you wouldn’t have to worry about your payments increasing.

On preview I notice that most of this has already been said, but the hell with it, I typed it so you have to read it.

5

The interest only loan can be very beneficial, but you have to work it right. Some friends of mine qualified to go this route and elected to since they had a conventional mortgage that was costing them about a grand a month and they needed more liquidity to cover tuition costs when he started college. The interest only loan was pegged straight to the prime, which at the time was running at a flat 4%. Servicing the interest only would run them about 350.00/month. If you pay only that, you’re not getting anywhere with the principal. On the other hand, if you make payments of 700.00/month, you pay the interest and also service a huge part of the principal while still coming out 300.00/month ahead on disposable income.

In a conventional mortgage you’re servicing interest nearly exclusively for the first twenty years anyway–you only really start paying off the house in the last ten years or so of a thirty year mortgage. It’s a neat little trick, but if you get paid every two weeks and make half a payment every payday at the end of the year you’ll make one extra payment that goes directly to the principal. That one extra payment per year will have you paying off your 30 year conventional mortgage eight years early–extra principal payments are very smart. Last year I paid about six hundred bucks toward my principal, whereas my friends ended up paying off over four grand. When they sold that house after two years on the interest only loan they gave themselves a nice little equity boost while still having more money every month to pay for his tuition.

The three things you really have to pay attention to if you’re going this route are first, how stable the prime rate is, and how much over prime are you paying versus the lowest rate available for a conventional mortgage. Secondly, you have to be very sure you’re disciplined enough to keep overpaying what you are expected to pay monthly and servicing the principal, because if you don’t do this you’re losing out on a big advantage of this type of loan. Third, who takes care of your tax/insurance impound? Without having a mortgage company taking care of payments and disbursements for taxes you could be looking at a big ass bill to pay every year if you don’t budget for it monthly.

Of course, you always have the option of going into a conventional mortgage if the interest rates look to be going up or if you just want the security of the expected again. So the answer to the OP is basically, “it depends!”

6

Sorry, I don’t get this? Was the conventional mortgage an old one at a high interest rate? Was the interest only loan at a promo rate? Refinancing an old, high interest, loan is usually a good deal - you can find calculators which tell you what interest rate differential makes this profitable. You have to factor in the potential for an increase in interest later. Companies are not giving out promo rates for your health.
Extra payments are a good deal if you’re planning to stay for a while. However, if you plan on moving or refinancing soon, the benefit is the interest on the prepayment less the tax break you get, less the interest you could earn on that money in some other form of investment. I don’t do it because the average rate of return on my portfolio is a lot higher than my adjusted interest rate, and because the increase in equity of my house from the California boom (I got in at the right time :slight_smile: ) overwhelms what little there would be from early payments. But it is fine as a kind of savings plan (since it is hard to take money out again) for a lot of people.

7

They had been in the house about six years when they went to the interest only deal–basically it was a home equity line of credit into which they rolled the entire principal of their existing mortgage. The conventional was at about seven or eight percent if I recall correctly, but the IO was pegged at prime, which was very low. It was a perfect interim solution, got them through the initial two years of his college, and they reduced their principal from around 95K to about 87K during the two years. They then sold the house for 153K and turned it around to a bigger house. The extra equity meant they had a big downpayment to get the best possible interest rate and they also had some money left over to pay off both cars, all their other debt and buy a few items the new house needed.

Whereas it wouldn’t have worked over the long run, in their case it worked out beautifully for that two years. It’s doubtful they would have been able to afford tuition and would have had to wait for him to get his degree.

8

Another benefit is one day it will be paid off, and you can have a big party and burn the mortgage, and shout like Daffy Duck “it’s mine, mine, mine!!!”

9

The only good benefit of an interest only loan is the lower payment. Specifically you have extra cash flow to do something else with it verse paying down the house. Something really popular right now are Pay Option Arms. Each month you can either pay Interest Only (IO), Principle and Interest (PI), Minimum Payment which is using equity from your property while you are there.

GW Bush has a pay option arm on his ranch.

Back to your question. If you are dealing in multipal propertys that you flip from time to time, then a pay option arm is perfect because you don’t tie up cash.

If this is your own home to live in then I recomend in most cases a conforming 30 year fix.

Arms are a more complicated animal.
Conforming loans arms are called 3-1, 5-1 etc…
Non conforming loans a 3-1 is called a 3-27 and a 5-1 is called a 5-25.

Non confoming ARMs are always lower interest then their fixed counter parts with the same bank. I’m talking about sub prome banks now.

Conforming Arms at banks are not always lower then their fixed counterpart at the same bank.

Right now for a conforming loan fixed loans are pretty close to the same interest rate as the arms. Hence one might as well get a fixed. If fixed sky rocket and the banks want to sell more Arms then the Arms might be lower.

If you getting a conforming loan backed by Fannie mae or Freddy mac and your going to stay in the home, I would get a 30 yr fixed interest rate. If you can afford more then i would add some extra money each month towards the principle. You can pay off a 30 year loan in 15 years easily just by adding a certain amount.

You asked about charging.

Brokers have several different fees.

Points on the back called YSP (Yield spread)
Points on the front called pre paid interest
Points on the front pre paid interest to get you a lower rate
3rd party fees, IE Appraisal, title, closing costs

The definition of 1 point is 1 percent of the loan. The broker can charge you anything you allow.

Each broker has overhead, the nicer the facility, the more brokers, usually more overhead the more you are going to be charged.

The question is, how many total points are you going to allow?

Listen carefully here:

This is what you do.

Figure out one loan type you want, ie 30 year fixed, X interest rate, X loan amount, conforming loan.
Obtain the good faith estimate and look how many points total your being charged.

Find another broker and have him quote the same loan. Tell this broker you you have a competitive quote but don’t tell him the number. Make him work for you.

Eventually you can go back to the first guy and get him lower. It’s not uncommon to only pay 1 point for the loan, which is a great deal.

The first guy that quotes you will try and charge you 3 to 5 points usually.

Try and find a broker who works by himself, has low overhead and does it on the side. They tend to charge less then people who only do this for a living.

I will end here. I could talk about this subject for days.

10

You guys are the best! This advice should save me enough money to pay for my membership here! I was really worried about that 19.95! I really appreciate all of your help and will probably go with the Fixed-Rate, which is the way I was leaning anyway.

A couple of you asked where I live. I reside in South Florida, where the housing values will almost never go down, plus I live in a pretty new ‘well-to-do’ area, where they are not allowing anymore housing to be built (the city just passed the new building laws).

[When you hit the reply button at the end of a post (like this one) the text of the previous one will automatically be put in quote tags, which you can see. You can put them in manually around the text you are replying to (like I’m doing) or highlight a portion of text and click on the rightmost icon above the reply box. You can click on preview post after you’re done to see if you’ve done everything correctly.]

Let me see if this works.
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11

If you’re planning on refinancing at some point, I’m guessing you’d be going for a fixed-rate loan at that point. If so - you’d get the then-current interest rate. My best guess is that would be higher than today’s fixed interest rate. So you’d save on the monthly payment now, but pay more later on. If you can swing the fixed-rate payments now, I’d seriously consider locking in at today’s rates.

Advantages of the interest-only loans: Lower rates. Lower payments. All your payment is tax-deductible. In the early years, your principal payment is a very small portion of the payment anyway. Lots of advantages in short if you only plan to be there for a few years. Also, I imagine there’s no restriction on paying a bit of principal each month in addition to the required interest payments.

Depending on the terms of the interest-only loan, you might be locked into that lower rate for a number of years - which might be most or all of the time you plan to stay there.

Another advantage of a variable rate mortgage: If you pay down extra principal, then each time the payment adjusts (presumably annually), then the new payment is calculated on the lower-than-expected principal, so the new payment is a tad lower than it might have been. With a fixed-rate loan, you don’t affect your current payment by paying ahead, you just shorten the term of the loan (and, of course, affect your taxes each year because you’re paying less interest than you would have).

You can use Excel to calculate what your payment would adjust to in 5 years (or whatever the lock-in term for the initial variable rate is), given the maximum possible interest rate adjustment. That can help give you a feel for whether you can afford to take that risk.

Anyway - only you know your current/expected future situation, and you just have to look carefully at all the terms of the various mortgages.

12

Is this true? When I was shopping for mortgages the shorter the term of the loan the lower the interest rates. 15 year had a lower rate than 30 which had a lower rate than interest only. If the interest rate is really lower then why don’t people take out interest only loans and pay some extra toward the principle and make it into a normal mortgage with a lower interest rate.

13

I can’t say that it is universally true that an interest only loan will have a lower rate than a fixed 30 year mortgage, but based on my recollection it was true at the time I was shopping for a mortgage. As to why people wouldn’t take a lower rate interest only loan, I believe it is the same reason why people don’t take a lower rate adjustable rate mortgage over a fixed rate mortgage. At the time I took the loan, I was assuming rates would rise and in the end that meant I’d actually be paying a higher rate with the variable rate loan.

14

I see so it is the adjustable part that makes the rate lower. I was never really interested in adjustable rate loans. Can you get 15 year and 30 year loans with adjustable rates? and are thoses rates higher or lower than an interest only loan.

15

IMO – If you can afford fixed rate, and plan on being there any significant lenght of time, it’s much preferable. No matter how you slice it, interest rates are still very low by historical standards. You want to lock that in.

16

I would never take out an interest-only loan on a house. We got a standard 30 year mortgage on our current home, then after two years refinanced it down to a 15. The payment is higher but (a) the house will be paid off before my kids graduate from HS, and (b) the amount of my payment that went to principle rather than interest was more in the first payment on the new loan than all of the payments over the last two years combined! :smiley: Going from a 30 to a 15 saves us about $280,000 in interest payments over the life of the loan.

Why would you want a loan where you aren’t paying anything against the principle? It sounds like renting.

Of course, if you are just planning to flip a house, it might make sense, but things have slowed down and people are getting stuck with houses they never thought they’d still own.

Interest-only loans are scary- so are 40 + year mortgages, both of which people are turning to in CA in oder to afford a basic home.

17

Flipping is probably the main reason why to choose this option. The other option is to find an investment vehicle that can at least: a) get a better return than the interest on the loan; or even better b) get a better return than the appreciation of the house. Option a) isn’t too hard to beat, especially if you have a long lock, like a 10 year interest only.

As other posters have mentioned, if you’re not going to be there for very long, and (this really makes it worth it, imo, which again, is like flipping) the house appreciates a lot, you can sell it and put that extra money into a more stable loan on a larger house, like if you’re going to get married soon.

18

I believe that at one point I had a 30 year ARM. (No one did interest only loans back then.) It’s a good deal if you have to buy a house now, and the interest rates are heading down.

In my case, we wound up having to finance our buyer at 12.5% in 1980, since the market was going to hell and interest rates were very high. We had a clause in the contract that he had to refinance when the rates went below this. It took a couple of years for this to happen, but when it did it triggered us buying a house and getting out of our rental one. Since the interest rate decline triggered the availability of our money, and was clearly going to continue, an ARM made sense. It was nice for monthly payments to decrease every year. When it hit what we considered to be close to the bottom, we refinanced with a fixed loan.
Today rates are going to increase or stay roughly constant for a while, so we went with a fixed rate, which is now lower than the interest only rates being offered.

19

It’s about the same as paying the interest on credit cards and not paying down the principal.
You provide the mortgage holder with a steady income and you stay in debt for life!
Credit cards are usually worse due to higher interest rates.
Both should be paid off ASAP!

20

Except that the debt on a credit card doesn’t represent an investment like a mortgage does.

I’m not advocating an interest only loan, but I don’t think it is the worst decision anyone could make, either. Since the average time in a house is about 7 years, you really don’t make that big a dent in your principal on a standard 30 year mortgage before you are selling the house. Additionally, what principal you do pay is simply a savings account of sorts because it just represents how much additional money you’ll get out of the house when you sell it: You’ll get your down payment + appreciated value + principal payments.