Interest Only Loans?

[ktschris]

I have been hearing a lot about interest only loans lately and was wondering if someone could explain what the benefit of this type of loan would be. Would it not really be like “renting”? Does the principle become due at some point during the loan? Thanks in advance.

[Mango]

Interest-only is an option that can be attached to any type of mortgage.

For example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly payment of $599.56. This is the fully amortizing payment -- the payment which, if maintained over the full term of the loan, will just pay it off.

In month 1, that payment divides into $500 of interest and $99.56 of principal. In month 2, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After 5 years the balance is $93,054. That is how mortgages amortize.

Now lets attach an interest-only option to this mortgage, available, say, for the first 5 years. That means that the borrower need pay only $500 a month during the first 5 years. There is no payment to principal.

If the borrower exercises the option, therefore, the balance after 5 years is $100,000. There is no amortization. Beginning year 6, the borrower must begin paying $644.31. That is the fully amortizing payment for a 6% loan of $100,000 for 25 years.

[ktschris]

So the benefit of this type of loan would be if you are not planning on staying in the home for more than 5 years to keep payments down? But then how would you be building any equity in the property?

[Mango]

So the benefit of this type of loan would be if you are not planning on staying in the home for more than 5 years to keep payments down? But then how would you be building any equity in the property?

If the property is not appreciating, and your making interest only payments, then you are not accumulating nay equity.
These loans were designed for people who get bonus income, were expecting large payouts, people who are self employed like lawyers who may get paid on a big case etc. The people who use this loan correctly prepay principle when funds come due. It is NOT designed to buy a house because it's the only way someone qualifies for a mortgage.

[destinsm]

So the benefit of this type of loan would be if you are not planning on staying in the home for more than 5 years to keep payments down? But then how would you be building any equity in the property?

Oh boy... I thought everyone knew this...

Houses appreciate at least 15% a year, so who needs to actually waste their own money and put it toward principal... :roll:

[andipandi]

Please be nice. Not everyone knows everything. See how nice Mango is to explain.

KTS, as someone who has learned the hard way I would not recommend IO loans. I know a number of people who did it to procure houses in sowal area for investment including us. If your house depreciates you are really in deep trouble. We had planned to sell it in a year now we cannot at a loss.

[destinsm]

Please be nice. Not everyone knows everything. See how nice Mango is to explain.

KTS, as someone who has learned the hard way I would not recommend IO loans. I know a number of people who did it to procure houses in sowal area for investment including us. If your house depreciates you are really in deep trouble. We had planned to sell it in a year now we cannot at a loss.

OK, I'll be nice this time...

The last time in our history that IO loans were as popular as they have been for the last few years was just prior to the Great Depression...

So basically if you are not educated and using them for what they are designed for.... STAY AWAY...

[Cheering472]

Oh boy... I thought everyone knew this...

Houses appreciate at least 15% a year, so who needs to actually waste their own money and put it toward principal... :roll:

I know alot about dentistry perhaps I can make you feel inferior by talking about endo or perio treatments.

I work in the investment industry and believe that housing doesn't always "appreciate at least 15% a year" (see housing bubble) but I wouldn't try to belittle you because you seem to believe it.

Kindness before knowledge please.

[Cheering472]

oops sorry...You apologized before I posted.

[destinsm]

I know alot about dentistry perhaps I can make you feel inferior by talking about endo or perio treatments.

I work in the investment industry and believe that housing doesn't always "appreciate at least 15% a year" (see housing bubble) but I wouldn't try to belittle you because you seem to believe it.

Kindness before knowledge please.


I was being a bit sarcastic in my comment...

[Cheering472]

I was being a bit sarcastic in my comment...

See I'm never good at sarcasm. I'll go back to my corner now. :oops:

[Donna]

IO loans are a very bad idea for one's primary residence or for people who can only afford a mortgage by using them, in my estimation. That said, there is another very good reason for the IO loan and it pertains to an investment (rental) property. If there is an annual loss on your investment property, you cannot take the tax advantage (depreciation) until after the sale of the property. However, if your accounting can show a break-even or slightly positive cash flow position, then you can take the tax advantage now. In our case, this makes a lot of sense because we are still working and need all the tax shelter we can get. Even so, I would probably not feel that comfy with an IO mortgage had we purchased our beach property in the past 2 to 3 years. For those who purchased earlier than that, your value to mortage, even in a slow market, gives you the comfort zone needed for an IO loan to work for you.

The worst misuse of these loans that I see are the young professional who wants to buy in an upscale market, but who cannot qualify under anything but the IO loan. They are typically purchasing a starter home or condo, in hopes of that property appreciating and escalating them into their dream home. In the case of expensive condos, particularly one must consider that it may take a very long time for that appreciation to occur. There are exceptions to every rule, of course. Good luck with your decision and purchase.

[ktschris]

Thanks to all who posted. First of all, I am NOT getting an IO loan. I was just curious to why someone would. I had seen it mentioned on the board a few times, and like in Donna's example, I know a couple who did this to get "the big house". I know just enough about high finance to look like an idiot, so I was in search of a good reason to have an IO loan. Thanks again.

[pmd8]

"Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery."

Charles Dickens David Copperfield 1849

[Bob]

Donna is correct about low loan to value ratios. Those who have low LTVs can take advantage of IOs. Best deal now is 30 year fixed with IO options out to ten years. Sadly, I'll bet over 9 of 10 borrowers with IOs don't fit this profile.

[Mango]

IO loans are a very bad idea for one's primary residence or for people who can only afford a mortgage by using them, in my estimation. That said, there is another very good reason for the IO loan and it pertains to an investment (rental) property. If there is an annual loss on your investment property, you cannot take the tax advantage (depreciation) until after the sale of the property. However, if your accounting can show a break-even or slightly positive cash flow position, then you can take the tax advantage now.

Donna: You can verify with your accountant, and I forget the exact amount, but I believe it may be 100K income or less, then you can deduct annual loss from an investment property off income. Otherwise you are correct in that it is deducted from capitals gains upon sale (provided there are capitals gains)

I/O loans worked well for people a few years ago when the spread between the short term bonds and long term bonds was wider and who bought before the market peaked, or put down at least 20% down payment. Right now, if someone were to consider an interest only 1, 3, 5, or 7 year, is if they are absolutely positive they will be selling or moving within the selected time period and have a low LTV in the event of the value decreasing, or have the ability to walk in closing with money in that event.
To me on a primary residence, the payment difference is so negligible between the fixed rate and I/O loan (since you are mainly paying interest only anyway the first 10 years of a mortgage) that it is not worth it,especially after your interest deduction on your primary residence. Also there is no real spread between the yields between the short and long term bonds which mortgages are priced from at THIS time.

[spinDrAtl]

Here is what I posted in another thread regarding interest only loans:

I've got an interest only loan on an investment property right now. I got the property at auction a couple years back, took some equity out of a second home that had appreciated considerably with a no closing cost equity line. Total loan to value on that property is around 33% now. This allowed me to pay cash for the new property, avoiding a bunch of closing costs on that one. Yes, the rate has gone up some, but the interest only payment is lower than any fixed rate I could/can get and the low payment allows this property to cash flow while it appreciates (which it has already). I'm not going to own this newer property for 15 years so I don't care about paying the principal - I'm concerned about positive cash flow.

In addition, the property has appreciated about 28%.