Interest Only Mortgage

[Rob9874]

I'm going to meet with a mortgage guy tonight to discuss our first mortgage. I was leaning towards an "interest only" mortgage, but then my mortgage guy is really for them. So I'm pretty sure it's the way to go for us. Some friends of ours are weary about them, so I'm asking you guys to talk me out of it. I think the main reason I'm posting is to work it out for myself in my head.

For those who don't know, an interest-only mortgage defers the principle payments for 5 years. So your principle doesn't start amortizing until year 6. Because it's now a 25-year amortization (on a 30 year loan) instead of 30 years, the principle portion of your payment after the 5th year is more, making your payment more. But, if you're like us, and thinking of getting out of the house before 5 years, I don't see the downside. Worse case scenario, we'd refinance before the 5th year is up, to avoid the larger payments.

But for someone looking to get into a first home, realize some appreciation, and use that for a down payment on a second home in a few years, why not do interest only? The argument is, "But you don't have any equity in the house. When you sell, you owe what you did from day one." However, my response is that you get all the equity that appreciated. Our good friends bought their home 2 years ago for $160K, and just sold it for $230K. That's a $70K profit in 2 years. About $2K of that was from the equity they paid in their payments. Another friend also bought a house 2 years ago for $122K, and just got it appraised for $175K. $53K in 2 years. Also had paid down his mortgage only $1K in 2 years. The Phoenix East Valley housing market has always been booming, and is showing no signs of slowing down.

If you're not planning to pay the mortgage off, why pay towards the equity in your payment? The money you put towards the house does not make any money. Consider these scenarios, both purchasing a $100K house, which appreciates to $150K in 4 years:

Scenario 1:
Conventional loan
After 4 years, you've paid $10K towards equity, so mortgage balance is $90K
Home sells for $150K
Profit = $60K - $10K that you paid towards equity = $50K

Scenario 2:
Interest-only loan
After 4 years, you haven't touched the principle, so mortgage balance is $100K
Home sells for $150K
Profit = $50K

The money you put towards equity doesn't grow. If you pay $10K towards equity, you get exactly $10K back when you sell it. Any profit you've made from appreciation is independent of the amount of equity you've paid towards the house. In fact, if you used that $10K over 4 years to invest in a 10% investment, that $10K would be even more.

OK, I think I'm sold on interest-only. This little exercise has helped me make sense of it. Unless someone can talk me out of it.

 

[Thegonagle]

In scenario 1, you have an additional $10K in equity to roll over into your next home purchase. That's 10K that you won't need to borrow and pay interest on next time around.

 

[Rob9874]

Originally posted by: Thegonagle
In scenario 1, you have an additional $10K in equity to roll over into your next home purchase. That's 10K that you won't need to borrow and pay interest on next time around.

Ah, but it's $10K you had to pay out over 4 years too. How is it different form putting that $10K into savings or investmnet (assuming you have the discipline to do so)? What is the benefit of putting it in your home over another form of savings (or paying off debt!)?

 

[sciencewhiz]

Originally posted by: Rob9874
(or paying off debt!)?

That's exactly what you are doing as you are building equity in the house.

 

[Wingznut]

If you are sure that it will be a short term endeavor, which the vast majority of first home are, then there's really nothing to be talked out of.

Another option you want to look into is an Adjustable Rate Mortgage with a balloon payment after 5 or 7 years. That's what we did with our first house... Saved a bundle on interest AND paid some to the principal.

 

[Rob9874]

Originally posted by: sciencewhiz

Originally posted by: Rob9874
(or paying off debt!)?

That's exactly what you are doing as you are building equity in the house.

$2K towards a 5% interest loan (which is also an asset) doesn't compare to paying off 10-20% consumer debt.

 

[Noirish]

You paid more interests in scenario 2 so you don't make as much in reality.

 

[Rob9874]

Originally posted by: Wingznut
If you are sure that it will be a short term endeavor, which the vast majority of first home are, then there's really nothing to be talked out of.

Another option you want to look into is an Adjustable Rate Mortgage with a balloon payment after 5 or 7 years. That's what we did with our first house... Saved a bundle on interest AND paid some to the principal.

Yeah, from what I've seen, interest-only mortages are ARMs too, which lowers you payment even more, allowing you to use it more wisely.

 

[Noirish]

Originally posted by: Rob9874

Originally posted by: Wingznut
If you are sure that it will be a short term endeavor, which the vast majority of first home are, then there's really nothing to be talked out of.

Another option you want to look into is an Adjustable Rate Mortgage with a balloon payment after 5 or 7 years. That's what we did with our first house... Saved a bundle on interest AND paid some to the principal.

Yeah, from what I've seen, interest-only mortages are ARMs too, which lowers you payment even more, allowing you to use it more wisely.

ARM can jump up to 2% a year.
when the interest rate starts to climb, you are in deep trouble.

 

[Rob9874]

Originally posted by: Noirish
You paid more interests in scenario 2 so you don't make as much in reality.

I paid the same amount of interest, and made the same profit. Where are you getting your figures?

What is happening is this. Say your mortgage payment is $1000. About $900 of that goes to interest, and $100 to principle. Well, in an interest-only loan, you only pay the $900 for the first 5 years. And in fact, it's less, because you get an ARM interest rate. Cnn.com showed a comparison with a $200K loan. Conventional 30 year was $1230/mo. 5 year ARM was $1030/mo. And 5 year interest-only was $761/mo. So it lowers your payment.

 

[Thegonagle]

But you continuously pay interest on a constant balance in an interest-only mortgage, instead of paying steadily less interest on the declining balance in a more traditional mortgage. (Come on, that should be obvious. Of course you pay more interest in scenario two.)

If the mortgage guy practically has you sold on it, then he's certainly done his job. Now your job is to run all the numbers, or get an impartial third-party, i.e., a financial advisor, to help run the numbers for you.

 

[spidey07]

you're gambling that you'll actually sell your house for more than you paid for it, and even more a 50% appreciation in 4 years. I'm guessing you've talked to your buddies whose homes have appreciated that much - that is due to the economy and real estate booming for the last 5 years. But let's face it, homes are overpriced right now when you compare median homes with median income.

Many believe real estate is highly overvalued at the moment.

I just think you are dreaming that you're house will be worth 150K in 4 years (what is that? like 12%/yr?). We are on a bubble now, meaning accept as little risk as you can.

Just thought I'd throw that out there. Interest only is fine if you know for a fact that you're selling the house in 5 years, the house will appreciate and the rate is low.

VIC/CPA would be best for this and they can poke holes in my analysis all they want. I'm an engineer, not a finance guy.


-edit- so in 4 years when rates are 10% will you be able to sell the house and will you be able to purchase another one?

 

[Rob9874]

Originally posted by: Noirish

Originally posted by: Rob9874

Originally posted by: Wingznut
If you are sure that it will be a short term endeavor, which the vast majority of first home are, then there's really nothing to be talked out of.

Another option you want to look into is an Adjustable Rate Mortgage with a balloon payment after 5 or 7 years. That's what we did with our first house... Saved a bundle on interest AND paid some to the principal.

Yeah, from what I've seen, interest-only mortages are ARMs too, which lowers you payment even more, allowing you to use it more wisely.

ARM can jump up to 2% a year.
when the interest rate starts to climb, you are in deep trouble.

Planning to sell before 5 years. Not sure where you live, but most couples in their late-20's/early 30's in these parts (east Phoenix area) don't keep their first home for more than 2-4 years.

 

[Double Trouble]

Unless you already have a ton of equity built up (which, as a first time home owner, you do not), an interest only mortage is a terrible idea. You're assuming a huge risk. Basically, if your house does not appreciate -- and given the current market situation, there's a decent possibility that the housing market will slow down considerably for a while -- you end up having paid interest, having built no equity, and owing a huge payment. Since your house did not appreciate (in that scenario), you won't have any equity and you won't be able to move out of the house to a nicer one either, and so you'll be stuck making big payments on your 'starter' home. At that point, you would be stuck in a starter home, with no equity, and no nest egg or security blanket to speak of. You couldn't borrow against your house, since you have no equity.

The housing market has been skyrocketing for years, so the risk doesn't seem as high... but there's no telling what the next 5 years might bring.......

 

[Rob9874]

Originally posted by: spidey07
you're gambling that you'll actually sell your house for more than you paid for it, and even more a 50% appreciation in 4 years. I'm guessing you've talked to your buddies whose homes have appreciated that much - that is due to the economy and real estate booming for the last 5 years. But let's face it, homes are overpriced right now when you compare median homes with median income.

Many believe real estate is highly overvalued at the moment.

I just think you are dreaming that you're house will be worth 150K in 4 years (what is that? like 12%/yr?). We are on a bubble now, meaning accept as little risk as you can.

Just thought I'd throw that out there. Interest only is fine if you know for a fact that you're selling the house in 5 years, the house will appreciate and the rate is low.

VIC/CPA would be best for this and they can poke holes in my analysis all they want. I'm an engineer, not a finance guy.


-edit- so in 4 years when rates are 10% will you be able to sell the house and will you be able to purchase another one?

Yeah, engineer too here. I hear what you're saying, but the Phoenix home market hasn't seen a decline in years (would have to research the data). Homes are popping up so fast here, that most secondary market homes sell within days, for full asking price. It's a newly developed area (bare fields just 4 years ago), and is growing like crazy. Gilbert, AZ is the fastest growing community in the US. I can't envision a scenario where the market would decline.

I understand it's a risk, but what good investments aren't? Also, in the case of a market decline, what benefit do I have if I have paid $10K into my home equity over a mutual fund? $10K is $10K, but at least there's a chance it will grow in a mutual fund. People confuse home appreciation with equity appreciation. I can't express this enough. Money paid towards the equity of your home NEVER APPRECIATES. It's the value of the home that appreciates, and not the equity.

 

[1cito]

IMHO its sounds like the interest only loan couldnt be more perfect for you situation.

i know they give you a much lower rate on the interest only loans. is there a penalty for paying off prinicple every month on the interest only loan for the 1st 5 years?

 

[Rob9874]

tagej, why is having equity in a house (which is miniscule the first 5 years anyway) better than putting that money to use in a mutual fund? I can always liquidate the fund, and use that money towards my second house. I think this is the point people are missing here. It's my opinion (and damn near a law) that money invested is smarter than money in house equity.

 

[Rob9874]

Originally posted by: 1cito
IMHO its sounds like the interest only loan couldnt be more perfect for you situation.

i know they give you a much lower rate on the interest only loans. is there a penalty for paying off prinicple every month on the interest only loan for the 1st 5 years?

None.

Going to meet with him now. Discuss amongst yourselves. I'll check the discussion later tonight. Good insight!

 

[Noirish]

Originally posted by: 1cito
IMHO its sounds like the interest only loan couldnt be more perfect for you situation.

i know they give you a much lower rate on the interest only loans. is there a penalty for paying off prinicple every month on the interest only loan for the 1st 5 years?

yeah, better ask about penalty, lenders aren't stupid.

* sigh * 200k houses...in the bay area, if you see a 500k or 400k houses, you'd say it's relatively inexpensive. i've been looking at houses that are around 500k, crazy market, i hope it crashes soon or at least come down from the peak.

anyone know where to find average housing prices year-to-year statistics? especially in the bay area (california).

 

[spidey07]

Originally posted by: Rob9874

Originally posted by: spidey07
you're gambling that you'll actually sell your house for more than you paid for it, and even more a 50% appreciation in 4 years. I'm guessing you've talked to your buddies whose homes have appreciated that much - that is due to the economy and real estate booming for the last 5 years. But let's face it, homes are overpriced right now when you compare median homes with median income.

Many believe real estate is highly overvalued at the moment.

I just think you are dreaming that you're house will be worth 150K in 4 years (what is that? like 12%/yr?). We are on a bubble now, meaning accept as little risk as you can.

Just thought I'd throw that out there. Interest only is fine if you know for a fact that you're selling the house in 5 years, the house will appreciate and the rate is low.

VIC/CPA would be best for this and they can poke holes in my analysis all they want. I'm an engineer, not a finance guy.


-edit- so in 4 years when rates are 10% will you be able to sell the house and will you be able to purchase another one?

Yeah, engineer too here. I hear what you're saying, but the Phoenix home market hasn't seen a decline in years (would have to research the data). Homes are popping up so fast here, that most secondary market homes sell within days, for full asking price. It's a newly developed area (bare fields just 4 years ago), and is growing like crazy. Gilbert, AZ is the fastest growing community in the US. I can't envision a scenario where the market would decline.

I understand it's a risk, but what good investments aren't? Also, in the case of a market decline, what benefit do I have if I have paid $10K into my home equity over a mutual fund? $10K is $10K, but at least there's a chance it will grow in a mutual fund. People confuse home appreciation with equity appreciation. I can't express this enough. Money paid towards the equity of your home NEVER APPRECIATES. It's the value of the home that appreciates, and not the equity.

when rates rise you will not have that scenario.

Personally I think interest only are great. but with the uncertainty right now it is a decision to be weighed heavily.

Example - I am a highly compensated employee (damn IRS) so anything I can do to lower my taxible income is a good thing. But look at the return rates over the last 50 years for real estate in your area...there are peaks and valleys. we are on a SERIOUS peak right now.

 

[Rob9874]

https://www.wfhm.com/wfhm/parsippanybranchnj/products.jsp#interest_only

The Interest-Only feature offers:
Reduced monthly payments
With our Interest-Only feature, your monthly payment consists of interest alone for the first five or seven years. This increases your cash flow ? making homeownership more affordable.
Financial diversity
Redirect your cash flow to supplement your savings or investment funds, maximize your contributions to 401k or other tax-deferred retirement accounts, or pay off any higher-cost, non-tax-deductible debt. It's your money to use as you see fit.
Greater tax deductions
Because payments are interest-only, you may benefit from larger interest deductions during the interest only period.*
Flexibility
You are welcome to make principal payments during the "interest only" period, but are not required to do so.

 

[1cito]

Originally posted by: Rob9874

Originally posted by: 1cito
IMHO its sounds like the interest only loan couldnt be more perfect for you situation.

i know they give you a much lower rate on the interest only loans. is there a penalty for paying off prinicple every month on the interest only loan for the 1st 5 years?

None.

Going to meet with him now. Discuss amongst yourselves. I'll check the discussion later tonight. Good insight!

whats to stop someone from taking the interest only loan (for the lower interest rate) and then just making the extra payments. isn't this a better way to lock in a lower interest rate?

 

[Thegonagle]

Originally posted by: Rob9874

Originally posted by: 1cito
IMHO its sounds like the interest only loan couldnt be more perfect for you situation.

i know they give you a much lower rate on the interest only loans. is there a penalty for paying off prinicple every month on the interest only loan for the 1st 5 years?

None.

Going to meet with him now. Discuss amongst yourselves. I'll check the discussion later tonight. Good insight!

Don't sign anything yet. You still need some impartial professional advice, IMO.

 

[spidey07]

Originally posted by: Rob9874
tagej, why is having equity in a house (which is miniscule the first 5 years anyway) better than putting that money to use in a mutual fund? I can always liquidate the fund, and use that money towards my second house. I think this is the point people are missing here. It's my opinion (and damn near a law) that money invested is smarter than money in house equity.

heh, guess you haven't been following the fund disasters going on?

 

[spidey07]

Originally posted by: Rob9874
https://www.wfhm.com/wfhm/parsippanybranchnj/products.jsp#interest_only

The Interest-Only feature offers:
Reduced monthly payments
With our Interest-Only feature, your monthly payment consists of interest alone for the first five or seven years. This increases your cash flow ? making homeownership more affordable.
Financial diversity
Redirect your cash flow to supplement your savings or investment funds, maximize your contributions to 401k or other tax-deferred retirement accounts, or pay off any higher-cost, non-tax-deductible debt. It's your money to use as you see fit.
Greater tax deductions
Because payments are interest-only, you may benefit from larger interest deductions during the interest only period.*
Flexibility
You are welcome to make principal payments during the "interest only" period, but are not required to do so.

and your risk is you will be selling (and can find a seller for what you want) in 5 years. You know people have been forced to sell their house for what they paid for it.