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Interest-Only Mortgages – What You Need To Know
By mortgage writer: Dave Leonhart
So, you’ve heard about interest only mortgages and their exceptionally low payments, and you’re wondering if it’s the right for loan for you.
Well, you’re doing the right thing by first researching the loan “before” you actually go out and get one. Because, as with most things if life, there’s a time and place when getting such a loan is a good idea, but you need to know if you’re a good fit for this loan program before signing on the dotted line.
For one thing, I the name of the loan is somewhat misleading. An interest-only loan implies that you’ll only pay the interest right? Well, not exactly. What you’re getting is an interest only payment, for a particular period of time. At some point in time you’ll have to repay the principal too. (There’s no free lunch, remember)
These loans have actually been around for sometime, but they have become more popular to mainstream homeowners wanting to lower their payments as much as possible in order to maximize their home buying purchase, and hopefully, make more money by their home appreciation.
They were originally designed for the so-called sophisticated, well heeled, investor types. The idea behind the loan was to reduce your monthly payment on your million dollar estate and invest the funds you ‘saved’ into another asset class such as, stocks or other investments.
Obviously, if you’re purchasing a multi-million dollar estate, and you get an interest-only mortgage the savings can be substantial.
Here’s an example— If you have a 6% interest rate with a $150,000 loan amount a fully amortized (interest & principal) the payment would be approximately $900 a month, of which $750 would be interest. Therefore, with an interest-only payment you would save $150 a month.
However, if you have a one million dollar loan and a 30-year fixed rate you’ll have a payment of about $6,000 a month; but with an interest-only loan, your payment is only $5,000. With that extra $1,000 a month, that savvy investor could take those funds and invest it, generating a return (hopefully) greater than the interest rate cost for the interest-only loan. If not, the savvy investor has the fortitude and financial strength to carry any loses if the investment goes sour.
Note: The above example compares an Interest-only loan 30-yr fixed rate loan to a standard 30-yr fixed rate loan. Many, if not most, interest-only programs are adjustable rates, and therefore have even lower monthly payments. But to be fair, you need to compare apples to apples to see the true value. If you compare an interest-only ARM to a standard 30-yr fixed rate loan, obviously, you will see a greater difference in the payments.
So, it is my belief, the advantages of these loans are sometimes promoted as if anyone who wants to simply lower their payment should consider getting one regardless of your personal situation… and that’s simply not the case.
In today’s hot real estate market, home buyers are using interest-only loans for a couple of reasons that I personally believe can lead to danger down the road. Some folks want to get an interest-only loan so they can become the highest bidder on home. (If you’re payment is less, you can qualify to purchase a property with a higher valued)
Also, some people get the loan in order to simply lower their payment as much as possible in order to hold the property long enough to sell it for a profit. Now, this sounds like a good idea, but you need to be careful, because property prices won’t always go up, particularly in the short run. So if your interest-only loan payment is for three years, and you will be selling your home in that amount of time, the interest-only seems may make sense. But what you have to consider is the other side of the trade… what if you can’t sell the property in that time period, and for the price you want, and you have to keep it longer? Can you handle the “full-payment, in the event things don’t turn out like you hope?” What happens if interest rates rise during your holding period and you need to keep the loan longer? Would you have been better off just getting a fixed rate loan and locking in the lower rate, just in case?
These are personal decisions you must decide based on your particular circumstances. An interest-only can be a good idea if your ownership time horizon is short, and you firmly believe that houses will continue to rise.
Most interest-only loans are ARMs, but they also can be had as fixed rates too, which of course adds an even more complicated dimension to these loans. Which to choose from?
Here’s a summary:
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