Interest only mortgage question

[Dtrigg]

I am considering an interest only mortgage. The reasons are not due to lower monthly payments or no down payment. Neither of these are issues. It just seems that it would be better for me to keep my funds invested rather than put them into the house. Don't know how long we'll own the house. Could be one year, could be 30 years.

What am I missing, and what are the pros and cons? I can't speak with my accountant for a while, but I wanted some input.

Thanks

 

[NsXMas]

Unless you can make out far better than the mortgage interest rate, with a high degree of certainty, I think it's safer and better to pay off the mortgage.

Plus, if house values fall, you'll have negative equity.

Also, I think interest only mortgages begin having balloon payments at some point in time. I'm not sure because I never looked into one, but many experts advise against it.

 

[Briank]

It comes down to what the money costs for the mortgage including the value of the tax deduction on the interest compared to what you can get investing your down payment. Also you have to remember that you need a roof over your head so even you rent you will have housing costs.

I live in the Midwest so I have not experienced the large appreciation in values that have occurred in CA. But as rates go up you may see things slow down in CA and even if you take a 15 year loan and pay extra you may end up side down but.

 

[nsxtasy]

I'm not in this business, but...

It seems to me that an interest-only loan has to do with the rate at which the mortgage is repaid (infinite) and NOT with the amount of money that is borrowed. So there should be no concerns about "going upside down" or whether or not there is a down payment. I'm assuming we're not talking about $0 down payment interest-only mortgages (which might not even exist, for all I know, since they would be a bad investment for the lender).

For example, you can have a house worth, say, $2,500,000 (remember, this is Santa Barbara we're talking about). And maybe you have some equity in it already, or you make a big down payment, so you borrow a mortgage of $1,000,000. If you take out an interest-only loan on that $1,000,000 at a rate of 6 percent per year, you pay $5,000 a month on the mortgage in interest, and $0 in principal. It's still an interest-only mortgage, but you have $1,500,000 equity in the house, and you're not likely to go upside down.

Am I missing something?

 

[Dtrigg]

Thanks for your comments and insight. The interest only mortgate I am looking at is a five year, zero down, ARM.

So, we use Ken's example, for simplicity sake, wouldn't I be better off using an interest only and investing the downpayment. $2,500,000 home with 20% down is $500,000 out of pocket that isn't earning anything. However if I invest the $500,000 rather than give it to the bank, and the interest only payment is 100% tax deductable, isn't that a more prudent use of my funds? At the end of the five year period (some go to 10 years) I would refinance the house.

I understand people can get into big trouble if they are using an interest only to purchase more of a house they can really afford, of if they don't have the dicipline to invest the otherwise down payment.

Thanks again.
Doug

 

[PoohBEAR]

Depending on the program, you will have either a 5 or 10 years IO. You will have that option for that period of time before the loan fully amortize to complete your 30 year amortization. As such, expect your payment a little higher to make up your IO period. oh, one thing that you broker wouldn't or sometime doesn't tell you is that IO loan cost alittle more that is build into the rate. so unless you really want to do interest only, keep it simple.

Want to save money? try NOT to waive impound account and add a year or more of SOFT prepay....it benefit you a quite abit. Soft prepay designs to keep you from refinance the house again within the prepay period, but if you sell your house, PP doesn't matter. Hard prepay on the otherhand is different, you pay the lender whether you sell or refi.....if you do it within the prepay period. ........

 

[NsXMas]

Even though the interest may be fully deductible (I think there is a cap to mortgage interest based upon the loan balance), you still have to pay tax on the interest you earn.

So basically to net positive, you have to make high enough interest on whatever investments you decide, so that the after tax income is greater than the after-tax deduction interest you pay.

That can be a tricky thing to do, and investments aren't guaranteed 100% to return a profit. Paying down the mortgage basically is a guaranteed return on your money, in the form of interest payments saved.

 

[nsxtasy]

Thanks for your comments and insight. The interest only mortgate I am looking at is a five year, zero down, ARM.

So, we use Ken's example, for simplicity sake, wouldn't I be better off using an interest only and investing the downpayment. $2,500,000 home with 20% down is $500,000 out of pocket that isn't earning anything. However if I invest the $500,000 rather than give it to the bank, and the interest only payment is 100% tax deductable, isn't that a more prudent use of my funds? At the end of the five year period (some go to 10 years) I would refinance the house.

Okay, now you're saying that you ARE talking about a zero downpayment loan - and the question you're asking is whether to go with a zero downpayment, versus a 20 percent downpayment. That's a totally different question (and basically has nothing to do with whether the mortgage is an interest-only mortgage or includes the payment of principal). You're simply asking whether to borrow more money, or less money.

It seems to me that the risks involved in doing so revolve around the following questions, which you should be asking yourself: (1) What kind of investment are you considering, and what are the chances that the investment won't earn more than you would be paying on the house (comparing total after-tax returns on the investment against the after-tax cost of the mortgage interest)? (2) Are you okay with the risk that interest rates may go up, so that your adjustable rate mortgage may cost you a higher rate in subsequent years than initially? (3) Along the same lines, how do you feel about the possibility that you may need to commit to paying much higher interest rates when the mortgage ends and you have to refinance? (4) If the amount you are borrowing does represent the value of your house, that means that the entire amount of the house is borrowed - in which case, as others have noted, you CAN get "upside down" (owe more than the house is worth) if real estate values turn down. Is this an acceptable risk for you? (5) Do you anticipate any additional borrowing during the mortgage term, for which the amount you have already borrowed prevents you from qualifying for the borrowing you might need?

Obviously, if you have an investment which guarantees that it will pay you more (after taxes) than the most that the mortgage interest could cost you (after taxes), then it's something of a no-brainer; borrow the additional money and invest it. The real question here involves the various risks noted above, that make it an assessment of probabilities (and downsides) rather than a cut-and-dried moneymaker.

EDIT: I see that Frank (NSXmas) was posting many of the same things while I was typing this response...

 

[NsXMas]

Ken gave a more concise response than I did.

In general, I think the interest only mortgage for investment strategy is a very aggressive, higher risk action.

One of finance's basic principles is the risk vs return curve.

If you pay off the house, you have 0% risk, and let's say 7-9 % return (depending on the interest rate, and the tax deduction combined). What other investment can offer that return with 0% risk? If there are, I'd like to know about it.

So let say you decide to put the money into an investment that pays 13% return. In order to get a higher return, you have to accept higher risk. Now you're more like gambling, than investing. I know of no conservative investments that guarantee 13% return with 0 to low risk.

I think your train of thought may be this: obtain a low interest mortgage, and invest it on something that will follow the federal interest rate. So as interest rates climb, your investment will return more than the mortgage interest which you have locked in.

However, the one thing to consider is that as interest rates climb, house values tend to fall. So you risk being upside down on your house even though your investments returns are rising.

The worst scenario in this situation is if you have to suddenly sell, due to some emergency, job transfer, or other unforseen circumstance. Since you put your money into higher risk investments, which also tend to be longer term to reduce the risk (the shorter term the investment, the higher the risk for higher return). Now the selling price of the house is substantially less than the mortgage you have on it, and your money is locked in a longer term investment that can't be easily liquidated.

I like to be aggressive, but just not with my house.

 

[PoohBEAR]

Another issue to keep in mind is that the higher LTV you go, the more it cost. Some try to go around it by doing 80/20 program to save MI. However, you will go into a loan amount cap...most about 650-750K. Regardless the case, every loan program is designed for its specific class of strategy. You need to decide whether you are an investor which flips the property every year or so.....or decide whether that it is your owner occupy home.

If you are afraid of loosing value on your home, it will most likely won't happen...but I may grow alittle slower than previous years. Everyone would like to have an American dream...to rent is NOT it.

 

[Carguy!]

Common sense dictates that if it were easier to take the money and invest it and make significantly more than what you are paying on your mortgage the banks would be doing that and not lending you money for your house.

There isn't any safe investment that will pay you more than what you will be paying in interest. If you have found something let me know but don't tell anyone else. If you are a gambler, you can invest the money somewhere else and hope to do better than what you are paying out.

Good Luck!

 

[huckster]

interest only products have recently created a lot of 'interest' among borrowers. Unfortunately, most potential borrowers are considering 'interest only' products from a monthly payment perspective. I really appreciate the fact that you are considering this option from a more advanced perspective than most borrowers.

as a guy in the mortgage business, i personally would not choose an interest only mortgage loan. Here is why: in an interest only loan (which is a close cousin to a negative amortization loan) you are basically never accruing any equity based upon your investment and the mortgage payment that applies to principal. Your only real 'return on investment' is based upon the speculation of property value increase. Which may or may not happen, and if it does happen may only occur at a slow rate. Assuming static property values, you have been paying an 'interest only mortgage' which is no better than renting the same property. (though of course you can deduct the interest payments).

in a typical market, you have 5-8% property value increases, the tax deduction, and the true equity accumulation based upon the reduction of principal loan balance.

Translation: if you are in a market with 3-5% property value increase a year, if you only plan on living in this house for two years, and you dont consider THIS house an investment, then interest only may be the thing for you. You walk away with nothing more than you started with (after realtor fees). And you had the privilege of living in said house for that two year period.

but hey, i'm not guru of interst only mortgages, so maybe someone else here can provide a different perspective.....