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I am planning to take 30 year term 10 year interest only mortgage. I know following are pros can cons of this approach:

Pros:

  1. possible free money, especially given low interest rates
  2. lower payments (wrong reason to do it)
  3. more liquidity and options in your money
  4. chance for significant gains if you have cash to pay for house and can funnel most "interest" payments to Roth IRA or 401K
  5. no issue with variable rate if you don't plan on being there long
  6. usually interest rate for this plan is low (usually 0.5% less )

Cons:

  1. If for 10 year, I only pay interest, My principle amount will still be same as what I applied for on day 1. Now I am locked with same lender, it limits my refinance options.

The loan does not have any penalty for pre payment.

I have following questions with respect to 10 year interest only plan:

  • Can I make any number of additional payments towards principle & hance reducing overall loan total?
  • With this plan, does any additional payment fully reduces the principle and nothing goes towards interest?

Look at below screenshot which compares three plans:

  1. Mortgage where you pay both interest and principle (Cell A to E in screenshot)
  2. Interest only (Cell K to M in screenshot)
  3. Interest only (Cell N to P in screenshot) but you on your own (no obligation) pay some money towards principle very month (I will pay $775 per month). If I pick this option, at the end of four year I would have save little over 6000$ when compared with option 1.

I am thinking of using option three. As there is no obligation on me to make additional payments towards principle. My plan is to still pay same amount every month using option3, that I would have done using option 1. Are there any downsides which I am not seeing?

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  • I don't know what your definition of "free" is, but it's not one I'm familiar with. Just because you aren't required to make any payments toward principal in the first 10 years doesn't mean you don't eventually have to pay it, either during the next 20 years or upon sale of the property.
    – chepner
    May 1 at 18:54
  • @chepner: I know I need to make that payment (towards principle) sooner or later. My point is, for first 10 years I am not obligated to pay principle. If I pay principle, I am paying reducing the principle. Keeping that, I am wondering what are possible downside
    – OpenStack
    May 1 at 19:38
  • Basically, you are in just as much debt after 10 years as you were in the beginning. It may be cheaper than renting, but you are still stuck with either paying the principal eventually or selling the house; you can't walk away as easily as if you had been renting.
    – chepner
    May 1 at 19:53
  • you are in just as much debt after 10 years as you were in the beginning: This is true only if I am not paying anything towards principle. My question is, if I match what I would have paid using plan one (1350 interest + 775 for principle) are there any downsides to this option?
    – OpenStack
    May 1 at 19:59

1 Answer 1

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The big problem with interest only mortgages in the 2005-2008 time frame was that they seemed like a great deal if prices continued to rise. People were able to "buy" more house than they could normally afford. There were even mortgages that had negative amortization, where the balance would grow over time.

When prices dropped some people found that they had a mortgage amount greater than the value of the house. They needed to write a check when they sold the house. If they couldn't do that, but they lost their job, some walked away from the house and mortgage.

In your example the reason why the idea of making a extra principal payment saves you money is that the interest rate on the interest only mortgage is lower than the traditional mortgage.

So if you can make these extra payments, and it does reduce the interest you pay each month because the balance is decreasing, then the extra payments will eliminate one of the big negatives of the interest only mortgage: no equity accumulation.

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