Pros and Cons of Interest Only Loans

Question

I currently have a home with an FHA loan which require me to make mortgage insurance payments for the next 4 years. I am considering a refinance and have came across the idea of interest only mortgages. What are the advantages and disadvantages of this. I do not see myself being in my home for another 5 years and expect that there would be significant equity once I am ready to relocate. Is this something that I should consider?

Answer 1

Pros:

• Your mortgage payment is lower

Cons:

• Your mortgage payment is artificially low, nothing goes towards principal.
• The rates are adjustable; given that rates are historically low, where do you think they will go?
• Given the variable rates, and nothing being paid to principal, you greatly increase your risk of paying on a home.

Before the housing bubble the conventional wisdom was to buy as much home as you could afford, thereby borrowing as much you can afford. Because variable rates lead to lower mortgages, they were preferred by many as you could buy more house.

This of course lead to many people losing their home and many thousands of dollars.

A bubble is not necessary to trigger a chain of events that can lead to loss of a home. If an interest only borrower is late on a payment, this often triggers a rate increase. Couple that with some other things that can happen negatively, and you are up $hit's creek.

IMO it is not wise.

Answer 2

Given the current low interest rates - let's assume 4% - this might be a viable option for a lot of people. Let's also assume that your actual interest rate after figuring in tax considerations ends up at around 3%. I think I am being pretty fair with the numbers.

Now every dollar that you save each month based on the savings and invest with a higher net return of greater than 3% will in fact be "free money". You are basically betting on your ability to invest over the 3%. Even if using a conservative historical rate of return on the market you should net far better than 3%. This money would be significant after 10 years.

Let's say you earn an average of 8% on your money over the 10 years. Well you would have an extra $77K by doing interest only if you were paying on average of $500 a month towards interest on a conventional loan. That is a pretty average house in the US. Who doesn't want $77K (more than you would have compared to just principal). So after 10 years you have the same amount in principal plus $77k given that you take all of the saved money and invest it at the constraints above.

I would suggest that people take interest only if they are willing to diligently put away the money as they had a conventional loan. Another scenario would be a wealthier home owner (that may be able to pay off house at any time) to reap the tax breaks and cheap money to invest.

Pros:

• possible free money, especially given low interest rates
• lower payments (wrong reason to do it)
• more liquidity and options in your money
• chance for significant gains if you have cash to pay for house and can funnel most "interest" payments to Roth IRA or 401K
• bank takes more of the risk from home market fluctuation
• bank takes more risk for something catastrophic happening
• no issue with variable rate if you don't plan on being there long

Cons:

• this is not for those with poor ability to save and invest money
• there is inherent risk when playing the market
• this is a long term strategy and might not pan out well in the short term
• your home loan will not be locked in at historically low rates
• if you do not save the "extra" money then you may never have a down payment to buy another house

Sidenote: If people ask how viable is this. Well I have done this for 8 years. I have earned an extra 110K. I have smaller than $500 I put away each month since my house is about 30% owned but have earned almost 14% on average over the last 8 years. My money gets put into an e-trade account automatically each month from there I funnel it into different funds (diversified by sector and region). I literally spend a few minutes a month on this and I truly act like the money isn't there. What is also nice is that the bank will account for about half of this as being a liquid asset when I have to renegotiate another loan.

Answer 3

The advantage of interest only mortgages is that they can increase your cashflow as you are only paying the interest and not any part of the principle. We have most of our investment loans on interest only for 10 years. When we got the loans about 6 to 7 years ago our LVR was only 60% and the property prices have increased by about 40% in that time. We also place our excess cashflow into offset accounts linked to the investment loans, so there is extra cash available in case things go bad.

The disadvantage of interest only mortgages is that you are not paying off any principal for the length of the interest only period. If you are over extended this could cause problems as you need to rely totally on the price of the property going up for your equity to increase. As you are currently paying mortgage insurance leads me to believe your LVR is above 80%, so you would not have much equity available in your home. With an interest only loan this could pose you some problems. You should never try to over extend yourself, the slightest thing that goes wrong could get you into financial troubles. Always try to have some buffer to help you stay on your feet if circumstances do change for the worst.

Answer 4

The main disadvantage is that interest rates are higher for the interest-only loan. It's higher risk to the bank, since the principal outstanding is higher for longer. According to the New York Times, "Interest rates are usually an eighth- to a half-percentage point higher than on fully amortized jumbo loans." They're also tougher to qualify for, and fewer lenders offer them, again due to the risk to the bank.

Since you can always put extra towards the principal, strictly speaking, these are the only downsides.

The upside, of course, is that you can make a lower payment each month. The question is what are you doing with this? If this is the only way you can afford the payments, there's a good chance the house is too expensive for you. You're not building equity in the home, and you have the risk of being underwater if the house price goes down.

If you're using the money for other things, or you have variable income, it might be a different story. For the former, reinvesting in a business you own might be a reason, if you're cognizant of the risks. For the latter, salespeople on commission, or financial industry types who get most of their income in bonuses, can benefit from the flexibility.