I was just curious about interest only loans and how people are using them. What are the advantages and dis-advantages. If someone could please help me with this I would appreciate it. Thanks, Joe.
Well interest only loans are great if you aren’t planning on holding the property long. You never pay down the principal and typically they are shorter in term with the principal amount due at the end of the term.
If you plan on holding it, lock in a good low rate now before they start to move up.
If you are going to rehab it, flip it, lease option, then Interest only might be a good thing for you.
I think I agree with Joe. If it is a property you plan to keep or rent and you don’t pay the down that can be a hefty payment. However on the other hand If all you want is to get the posession and refinance it soon as you have posession could change things. Either way it plays out like a 100% loan.
Here is a brief Segment of an article Written by The Mortgage Professor on www.mtgprofessor.com There is much more information on the site and there are tables and spreadsheets as well. Interest only loans are the talk of the town nowadays and unfortunatley both borrowers and loan officers alike often times do not have enough information to make an educated decision. For the borrower it is a lower payment, for the loan officer it is an easy sell…here are some of the facts:
- What is an interest-only mortgage?
- For what types of borrowers is it suitable?
- What are the hazards you should watch out for?
- What information do you need to assess an IO mortgage?
- How do you get this information?
What Is An Interest-Only Mortgage?
A mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make --consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want to.
If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged.
For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast, borrowers who have the same mortgage but without an IO option, would have to pay $615.72. This is the “fully amortizing payment” – the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is “principal”, which go to reduce the balance.
For a more complete illustration of the difference between an interest-only and a fully-amortizing mortgage, see Interest-Only Versus Fully Amortizing.
For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
Interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences.
Pay Principal When Convenient: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial payment to principal.
Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to.
Buy More House: It is common for families to begin with a “starter house”, then move into a more expensive house as their incomes rise. This process of “trading up” carries high transaction and moving costs.
You can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but the IO mortgage may make it manageable.
Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize.
Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.
A valid example is the young borrower with a long time horizon who invests in a diversified portfolio of common stock. This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return investing in their own businesses.
Ask yourself whether you really will invest the excess cash flow, as opposed to spending it; and whether you have a firm basis for believing that your investments will yield a return higher than the mortgage rate.
What Are The Hazards You Should Watch Out For?
The major hazard is being deceived into accepting an interest-only mortgage that does not meet any of the suitability tests described above. The deceptions are about alleged desirable features of IOs that don’t exist.
Borrowers can immunize themselves against most deceptions by remembering one critical fact. If two mortgages are identical except that only one has an interest-only option, lenders view that one as riskier. The reason is that, after any period has elapsed, the loan with the IO option will have a larger balance.
Deception 1: An interest-only loan carries a lower interest rate. Lenders sometimes charge a higher rate for an identical loan with an interest-only option, for reasons indicated above. They never charge a lower rate.
The deception arises from comparisons of apples and oranges. Most interest-only loans are adjustable rate mortgages (ARMs), and ARMs have lower rates than fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates than FRMs because they are ARMs, not because they are IO.
Deception 2: An interest-only loan allows the borrower to avoid paying for mortgage insurance. Since loans with an IO option are riskier to the lender, the option cannot cause the disappearance of mortgage insurance.
Any IO loans with down payments less than 20% that don’t carry mortgage insurance from a mortgage insurance company are being insured by the lender. The borrower is paying the premium in the interest rate rather than as an insurance premium.
Deception 3. On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. It is not. The interest-only period is the period during which you are allowed to pay interest only, usually 5 or 10 years. The period for which the initial rate holds can be as long as 10 years or as short as one month.
Deception 4. It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.
There is no magic connected to amortizing an interest-only loan. A borrower who takes an interest-only option but decides to make the fully amortizing payment instead will amortize in exactly the same way as the borrower who takes the same mortgage without the option. Read Does an an Interest-Only Amortize Faster? …
to read the article in it’s entirety go to www.mtgprofessor.com.
Good Luck everyone!