Friday, October 2, 2009

Pros and Cons of Interest Only Mortgage

I recently came across this article on a finance blog I read regularly and I cannot agree with it more. Getting an interest-only mortgage can seem like a great idea when you’re trying to buy a house and can’t afford a down payment (or if you have bad credit), but odds are that this is actually a disaster waiting to happen. Most people who sign up to interest only mortgages can't afford the house to begin with. In summary, interest only loans carry the risk of market affects on your property as well as having the monthly payments balloon as your principal payments start to kick in.

The Pros
There are two reasons an interest-only mortgage might work out for you:

Reason #1: You’re a house flipper.
No down payment, lower monthly payments for ten years — since you’re flipping, you probably plan to have the house for less than a year. Why bother paying more? Using interest-only means that you can direct more capital into fixing up the place.

And since your goal is to increase the value of the house, you probably won’t have to sell it for less than the mortgage. Congrats. You have an excellent reason to take out an interest-only mortgage.

Reason #2: You plan the stay in the home for all 30 years.
In the end, you’ll spend the same amount of money with an interest-only or a normal mortgage. If you plan to stay in the home, have a well-paying and steady job (perhaps you work for the government and the bureaucracy make you impossible to fire), and want to invest the money you’ll save in the beginning to take advantage of compounding, then get the mortgage if you absolutely must.

The Cons
Here are two reasons an interest-only mortgage is probably a bad idea:

Reason #1: You don’t build equity
Imagine you have a $100,000, 30-year mortgage at 6.25% with the first ten years as interest-only. (The calculators listed at the end of this article can help you run the numbers for different values and rates.) While the money you pay for those first ten years — $62,500 — will have value if you stay there for the full thirty years, it will be little or no better than renting if you move earlier.

Actually, it could be much worse than renting. If you need to sell before the interest-only period is over, you’ll still owe the full value of the mortgage ($100,000 in our example). If you can sell it for more, you come out ahead. But if you sell it for less, you’ll still owe the difference. In today’s housing market, that’s particularly worrying, since the odds are high that your property value will decrease.

So if the house sells for only $95,000, you’ll owe the $5000. When selling your home, there’s always a risk that you’ll lose money anyway, but an interest-only mortgage dramatically increases it. (And these are low numbers — suppose the mortgage is $250,000 and you sell it for $225,000!)

On the other hand, by going fully-amortized during those first ten years, you could build $15,223.87 in equity. That’s more than you’ll save by paying interest-only. Under an interest-only plan, it’s only around the 25-year mark that the equities equalize. Until then, you’d be ahead with the normal mortgage.

Reason #2: The amount due will increase
In this example, having an interest-only mortgage saves you $94.89/month at the beginning. That’s $11,386 in payments over the first 10 years. However, after the 10 years, your payments go up by $210/month. Now you’re paying over $100 more than the amortized rate and you have to find that extra money in your budget.

This might make financial sense, say, if you were in a secure job or field where you could be sure that you’d have the extra money within 10 years. But what if you lost your job (see #1 about having no equity)? Or what if you had more children and expenses? In the world of finance there are few guarantees — except that if you can’t pay the new rate and can’t refinance, you’ll be in trouble.

Looks like a bad deal, doesn’t it?

The Decision
Before you say an interest-only mortgage fits you, think long and hard. Consider the reasons it’s a bad idea for most people. If you’re the one in a million who actually could pull it off, then go in with eyes wide open. And best of luck to you!

Otherwise, I suggest that you avoid these like the plague. Are they better than adjustable-rate mortgages (ARMs)? I don’t know. Possibly, since you should know ahead of time what you owe and what the interest rate will be. But it’s like comparing arsenic and cyanide. You’re best off not taking either.


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