The pros and cons of an interest-only mortgage

This is a guest post from Mrs. Micah of Finance and Life. Look for a related post later today.

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). Earlier this week, I read the story of a couple who are celebrating home-ownership under just such a situation. But while they're happy, odds are that this is actually a disaster waiting to happen.

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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Jeff
Jeff
12 years ago

What if you CAN afford a regular 30 year mortgage and you pay above your interest only payment? In effect you are only required to pay the interest only payment but can afford to pay more than that. So you get into a house without a down payment and avoid PMI and pay your extra principal payment monthly. If you look at the amortization table the early years are pretty much interest only anyway! If you are disciplined and make principal payments I would say this could be better than a run of the mill 30 year mortgage IF you… Read more »

jb
jb
12 years ago

I don’t understand, couldn’t you get an interest only loan yet still make principle payments quarterly or yearly?

The Saving Freak
The Saving Freak
12 years ago

If you are disciplined then interest only can be a good tool. The problem is most people are not disciplined int their finances. So you eventually see the bill and rationalize that it is o.k. to just pay the minimum.

Curtis
Curtis
12 years ago

If I’m buying so much house that it stretches my budget so that I can’t afford to pay $98 in principal from day 1… then I need to look at a less expensive home! Other than investors who turn houses quickly, there is really not much sense in interest only. It just provides yet another way for people to buy more house than they can really afford.

The Financial Philosopher
The Financial Philosopher
12 years ago

Everything in personal finance boils down to self-acquaintance, simplicity, and moderation… I will, at least, offer that writing a blog post with “one-size fits all” suggestions is difficult. The only “size” that fits is your own. Following the “path” of others is almost always wrong… With that, I’ll say the only real reason to use an interest-only mortgage is to increase cash flow for whatever purpose the borrower may have at the time. In other words, the borrower has an opportunity to use the “freed” cash in such a way that can provide a greater “return” on that money than… Read more »

Heidi
Heidi
12 years ago

Interest only mortgages helped fuel the current sub-prime disaster. I agree with Curtis, if you can’t afford the princial from day one, you probably need to look for less house.

Few people are disciplined enough to make this a wise investment strategy. Anyone getting an interest only mortgage thinking that appreciation will set them free has another thing coming this year – I just heard on the news this morning that (nationally) home values are down 4.2% from this time last year.

Patrick
Patrick
12 years ago

Different types of mortgages for different types of financial situations. We have an Interest-Only (low) fixed rate mortgage and with discipline, you can pay an amount towards your mortgage principle at the start of your mortgage. In our case, we currently pay the exact mortgage amount that we have to pay after the 10 year no-interest period is over. If something unfortunate happens in our financial situation, we can reduce or eliminate principle payment till the situation gets better. No stress of thinking: I have to sell my house because I can’t afford it. If the situation stays as is,… Read more »

Jeremy
Jeremy
12 years ago

Wow. 6 posts (when I posted this) and only one person mentions the sub-prime problem that’s happening.

It’s surprising that the author didn’t mention that it’s going to be almost impossible to qualify for these types of loans from now on due to the escalation credit crunch.

I’m of the mind set that if you can’t qualify for a 30-year fixed, don’t bother. Save some money and rent.

FinanceAndFat
FinanceAndFat
12 years ago

Great post, very clear and straightforward breakdown.

I agree with some comments that you could use an interest-only loan wisely, but my perception is that most people who took interest only loans did so in order to buy a house that they probably couldn’t really afford in the first place.

That being said, I think it is still far better than an ARM. You just open yourself up for all kinds of risk if you go the ARM route.

Rhonda Porter CMPS
Rhonda Porter CMPS
12 years ago

Interest only mortgages can be excellent financial tools for the right circumstance. Your home equity is not “earning” any interest, it’s stagnant. If one invested the difference into an interest bearing account, they would probably be financially better off. In your scenario of someone losing their their job; at that point, they would not have access to their equity (unless they have an untapped HELOC) since they would not qualify unemployed. In this case, they would again be better off in the scenario I described where they would have the funds earning interest to rely on if needed. I’m not… Read more »

Rhonda Porter CMPS
Rhonda Porter CMPS
12 years ago

Fixed period interest only mortgages are not what has fueled the mortgage melt down. They are not subprime mortgages…in fact many are Fannie/Freddie.

The mortgages that have been the most damaging IMHO are:
-stated income (especially when the borrower was not self employed).
-option arms (this is different than fixed period interest only).
-subprime 80/20 allowing dti’s of 55% (full doc).

I’m a new reader to this blog…so forgive me if this has all ready been addressed: the big culpret is Wall Street and the rating system which did not disclose the risk of these types of mortgages.

Fiscal Musings
Fiscal Musings
12 years ago

I don’t have a problem with interest-only mortgages if you’re using them to your advantage. They’re a great option if you’re purchasing a rental property because you’re able to maximize your cash flow.

I wouldn’t use one for my own place though. Like was said before, if you can’t afford a little extra principal payment, you probably should look for a different home.

JACK
JACK
12 years ago

Besides the issue of how interest only have fueled the sub-prime crisis and caused people to buy more than they can truly afford (and inflated home prices above what they should be) isn’t it true that most interest only’s are also ARMs? I never looked into it deeply when I purchased because I knew from day one I wanted a 30-year fixed, but I was under the impression that most interest only’s were ARMs.

Anne
Anne
12 years ago

I have an issue with con #1, particularly this quote: “When selling your home, there’s always a risk that you’ll lose money anyway, but an interest-only mortgage dramatically increases it.” An interest-only mortgage increases the risk that you’ll have to bring cash to the closing. It has nothing to do with whether the value of your home itself decreases. If you buy a home for $100,000 and sell it for $95,000, you have lost money whether you have equity in the property or not! If you use an I/O judiciously, putting the money that would otherwise go to principal into… Read more »

Money Blue Book
Money Blue Book
12 years ago

I think this is a good general overview of the basics. But sub prime issues will continue to make it very difficult for many to qualify for and obtain mortgages nowadays. A lot can be said for renting right now..
-Raymond

Ernesto
Ernesto
12 years ago

When researching this article, it sounds like several weak assumptions were made: 1. IO loans are fixed rate. I’d bet 95% are ARM loans. 2. You purchase a house and put no money down. 3. The IO in not a refi where the homeowner has mucho equity. 4. Makes no mention of people with variable income who during lean months benefit from lower IO payments. I have an IO loan; when I took it out I ran an amortization schedule for a fixed rate loan of the same size & interest rate and I make those payments. If the budget… Read more »

Jeff
Jeff
12 years ago

A year or so ago, my wife and I were doing some planning and realized that due to her health, my mother-in-law would probably have to sell her house and move in with us. She had always said that when that happens, she will give us the proceeds from the sale of the house. That got me thinking – maybe I had found a case for an interest only loan. My wife and I would buy one of the first houses that were built in a subdivision and finance it with an interest only loan using the equity that we… Read more »

Mrs. Micah
Mrs. Micah
12 years ago

I agree with most of the comments about being disciplined in using an IO–making extra payments on the principle and such. A person who’s very aware of their personal financial situation might be able to pull that off (whether you’re a financial professional or a regular GRS reader). While I’m not particularly a Dave Ramsey follower, I agree with him that the odds are people will find other ways to spend the money. IOs can be good tools in certain circumstances or decent tools and aren’t evil in themselves. But they make it possible for people to get themselves into… Read more »

Aaron Pinkston
Aaron Pinkston
12 years ago

“…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.” When I read this I was wondering at what interest rate? A 0% interest rate assumption (which is how the comparison is shown) means that person spent the money rather than saving it. Everyone should run the numbers for their own situation. Besides if you loose your job during the next 10 years and need to access your equity, it is a lot easier to write yourself a check from your savings account than to qualify for a… Read more »

Jay S
Jay S
12 years ago

When my wife and I purchased our home several years ago, we went through this consideration. One factor that is left out is this. We had very little down payment (10k), and felt that buying a home was in our best interest. Our loan options were getting a 80/15 or a 95% loan with PMI. We opted for the 80/15. The rate on the IO wasn’t that much higher than the standard (at that time, maybe 1/8th). We then took the principal that we would have been paying on the 1st and paid it to the second (which has a… Read more »

Livingalmostlarge
Livingalmostlarge
12 years ago

It’s a numbers game. For most people I/O loans won’t work because they won’t save the principal. It also doesn’t matter if you pay down the house or saved the difference if the value of the home dropped from $100k to $95k. Either way you lost money. Arms are not bad. They also have their place in the financial playbook of life. I have an Arm. I am saving about $60k by getting an Arm. It will take me about 5 years after my 7 year fixed period to make up the difference of interest savings the first 7 years.… Read more »

Heather
Heather
12 years ago

As a recent (two weeks ago) homebuyer, I’m going to throw my two cents in. When I originally spoke to my mortgage lender a few months ago, it turns out I didn’t qualify for a 30-year fixed, but it wasn’t the typical situation. I have an excellent credit score and a decently high, stable income. The problem is that I owe about $100K in law school loans, and the market is cracking down so much that I just tipped over the income/debt ratio to qualify for a fixed. It wasn’t that I couldn’t afford the fixed rate payment, and I… Read more »

Dom
Dom
12 years ago

In response to Jeff’s original comment, rather than paying an additional amount on your mortgage (toward principle) you would be better off investing in your 401k or pretax retirement accounts. Why not reap the benefits of compounded interest.

bugmom
bugmom
12 years ago

We have a fixed IO loan ad here is why: We are involved in a seasonal business, in particular, farming. Our business income can be very irregular. When it comes (I emphasize *when* because we’re bracing for a very bad 2008), it is in a lump sum in March or November. I chose the IO because we can make the monthly payments on our salaries. Then, when our farming income comes in, I allocate that to several accounts: next year’s vacation, home maintenece and improvement fund, retirement and education savings (above the monthly amounts) and mortgage principal. If we have… Read more »

jack
jack
12 years ago

Surprising that this article is even on this website. Her presentation is ridiculous. Does anyone really know anyone that has succeeded with these types of loans over the course of 10/20/30 years. If your last paragraph contains the sentence, “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!” then you should not be in the financial advice game. Too many people giving advice. Hey I have great health advice its called Russian Roulette, take a six shooter, load five bullets and hope that… Read more »

klauss
klauss
12 years ago

Jack,

Your opinion was not very humble. Anyways, the IO loan can work well. If I was presented with an IO fixed rate loan and a standard P & I loan with the same rates, I would take the IO loan. I already pay more than needed on my current mortgage and would do so with an IO loan, but it would be nice to have the flexibility of temporarily having lower payments if needed IMHO.

Siena
Siena
12 years ago

Honestly, and I hate to say this, but I am one of those who got a mortgage without knowing really what I was doing. I have an interest only mortgage now but I pay an extra $200 a month and put that I want it to be added to the principle. I also have an ARM (one mortgage only–no heloc) and the rate is currently 4.75 (for 5 years) but will reset in 2 years. I saw online that the arm span (?) is 2.75 percent. Someone told me that when my low rate expires in 2009, each year after… Read more »

Ian
Ian
12 years ago

A few things. I work in a bank in the secondary marketing mortgage department so I see these things on a daily basis. IO loans are also “safe” if you plan to refinance after the IO period ends assuming that your house has appreciated. Even with a horrible housing market, it’s hard to believe that your house wouldnt apperciated 10 years from now. Either way, def a risk you are taking. As one user pointed out: “It’s surprising that the author didn’t mention that it’s going to be almost impossible to qualify for these types of loans from now on… Read more »

Ian
Ian
12 years ago

Siena, The 2.75 is the margin and tells you by how much your rate will go up from the index when it first adjusts. Your index is either the Libor or TBill. Your docs will say. The tbill today is about 3.9, so 3.9+2.75 = 6.65 would be your rate if the index were still 3.9 when your rate adjusts. The 2nd peice is the caps. Most likely you have a 5/2/5 or a 2/2/6. This tells you by how much your rate can go up on the each adjustments and also tells you MAX rate you will go up… Read more »

jack
jack
12 years ago

Klauss your right it was not very humble. But why mess with all this junk. I would hate to think of my mortgage adjusting and having to pay more or paying every month and knowing that it is not going down. I had a I/O heloc and it pained me to see that thing never move. So I changed it to a fixed rate. Siena I would do the same. Your mortgage will be fixed and that is comforting. It is hard to hear but if you cant afford the fixed rate maybe you can not afford the house. I… Read more »

Mrs. Micah
Mrs. Micah
12 years ago

I’m highly amused that Jack picked up on my last sentence while Ernesto picked up on the cyanide part. 😉 Some see only the the (apparently objectionable) pros, some see only the (apparently objectionable) cons. Apparently, Jack, people are pulling off IOs if you read the comments. I’m sorry you don’t like my writing style and didn’t pick up on the wryness in the last sentence (as in, “Good luck–you’ll need it!” Everyone else did and got offended 😉 ). Ernesto, you’re in one of the situations where having an IO is probably not a huge mistake, as I said… Read more »

jack
jack
12 years ago

Mrs Micah I am surprised that you ended the article like that, especially if this was for First time home buyers. Joking or not. And are they really “pulling it off” and if they are then for how long will they be able to “pull it off”, and still get ahead. If this article WAS intended for first time home buyers then it was even worse advice, because if they have to get into some crazy loan, like an ARM or and I/O just to get in the market then maybe they can not afford to be in the market.… Read more »

SingleGuyMoney
SingleGuyMoney
12 years ago

I too have an IO mortgage. I could have qualified for the fully amortized payment but I chose to use the difference to payoff my debt. I have had this mortgage for a yr and a half and I have paid $200 minimum in principal every month. I plan to refi or sell in a yr or two depending on how the market is going at that time.

Siena
Siena
12 years ago

Thanks Ian, for the info. I will look into my paperwork (or maybe it’s on my online account)–I don’t know what kind of mortgage I have other than it’s an ARM. Jack, I honestly don’t know if I can afford my home after the increase. If the increase is around $500 a month I can afford that without being too stressed out. If it’s $1000 a month, I’d be screwed. And this is now when my car is paid off (woo hoo!) so I don’t have a car payment. When my loan resets I will look into refinancing and see… Read more »

Mrs. Micah
Mrs. Micah
12 years ago

Jack, I compared IOs to arsenic (or maybe cyanide–I don’t remember which one ARMs was). Not exactly subtle… 😉

Rhonda Porter CMPS
Rhonda Porter CMPS
12 years ago

Siena, please dig out your note and follow the advice from Ian in comment 30. It’s crucial that you (and everyone) with an adjustable rate mortgage understand how and when it will adjust and what the “worse case scenario” will be.

Bankrate did an article earlier this year (I believe) that a majority of Americans have no idea what the terms of their mortgage are. You are not alone.

jtimberman
jtimberman
12 years ago

I’ll go out on a limb here and say that interest only loans are stupid. Sorry if you take offense at that. Maybe I’m wrong, but no matter how you sugar coat IO loans (pros in the post, reasons given by people above), never applying any money to repay a loan is just plain irresponsible, lazy and sloppy. Not to mention that if you even need an interest only loan you clearly can’t afford whatever it is you’re buying with it. Of course, that goes without saying for anything you buy. If you can’t pay for it, you’re not ready… Read more »

Eric S Doms
Eric S Doms
12 years ago

I think the interest only mortgage makes sense in the beginning of the purchase so that cashflow is a little easier at first.

After 2 years or so it’s better to swop to full payment after rental / cashflow has increased and you can therefore afford the extra cost.

Amit
Amit
12 years ago

Can anyone explain in layman terms what an IO mortgage means?

pioneer
pioneer
12 years ago

I am not a financial guru but…..I do believe that there are people jumping into the housing market that really can’t afford it. (like me 15 years ago….I am more educated now !) Many people have it in their mind that they HAVE to own a home and they don’t really take everything into consideration.
Love this website !!

Rhonda Porter CMPS
Rhonda Porter CMPS
12 years ago

And the nice thing, Eric, is that the borrower can pay additional principal on their own; they don’t have to incur the cost of a refinance when they decide to make a “full” payment vs i/o.

I am biased towards fixed period i/o mortgages because of the flexibility they afford consumers.

With that said, not all mortgages are right for everyone.

Swim Upstream To Wealth
Swim Upstream To Wealth
12 years ago

Interest only are not bad loans. You have to understand them to use them effectively. A traditional 30 year fixed mortgage repays very little principal in the first few years anyway so an IO can free up cash flow. If you use the cash flow for productive means such as reducing other debt or investing, then it is a wise move. If you use the free cash flow to buy consumer goods, then the traditional mortgage might be a better path (a forced savings). It comes down to your level of knowledge and comfort. Generalized statements such as IO loans… Read more »

jack
jack
12 years ago

Well Mrs Micah,

Like the piece or not, you got people talking, and that is good. Well done.

I agree with jtimberman I/O are stupid. Like 0% credit cards and car leases. They seem like bait and switches. Can you beat them, yes, but in Vegas, you can win at roulette but your better off at craps. Odds are better.

I hope everybody makes it. I want people to be in their homes happy and working, I hate seeing people struggle. Myself included.

happy holidays.

livingalmostlarge
livingalmostlarge
12 years ago

Another argument most people forget is they are writing from an AMERICAN perspective. In other countries a fixed rate loan is UNHEARD of. In Canada, UK, Australia they only do Arms.

And people there aren’t in the same bind. Why? Because they view it differently. They don’t overbuy homes. They don’t put 0% down. Lending requirements are stricter. That is one thing about it.

Erin
Erin
12 years ago

“and I also knew my credit was good enough to refinance if I kept the property for 5 years” First of all, congratulations on your new house! And I think it’s great that you are able to refinance quickly and have equity already. Sadly, many, many people thought they could refinance before their ARM I/O was due to reset. But, the market went down and BOOM! now they owe more than their home is worth. And can’t refinance. Thousands of homeowners across the US are in that situation (look at San Diego, Las Vegas and Phoenix for some examples). Their… Read more »

EastCoast
EastCoast
12 years ago

I have an I/O. I bought before I’d completed the closing on a Manhattan condo. The new place was worth less than the old and the equity from the place I was selling was over 500k. So the I/O enabled me to close on my new place while closing out the sale on my old place. And I had the cash to carry me in case the closing was delayed. When my old place closed three months later, I paid off the majority of the I/O. I still have the I/O which now has much lower payments and it suits… Read more »

gs
gs
12 years ago

I just found this site, and while I enjoy it, the talk of “affording” homes and judgment based valuations are sort of sickening. Let me explain: I do not want to put my equity in my home. I’d rather pay for this convenience by the hedging costs on interest rate volatility (so fees option contract = hedging costs) and can adjust those for my own personal, monthly volatility. In fact I can even set it up so there’s a nice payoff, more than the value of IO loan, should interest rates shoot up. The downside is known, I doubt interest… Read more »

Sandra barr
Sandra barr
5 years ago

I have an interest only mortgage lasting another 14 yr, my mortgage is a shocking one which I pay 3.9 above Bank of England rates. I’m in debt and managing low I retest free payment but not getting debt paid off. My creditors are offering me settlements but I am wanting to apply for new mortgage in a couple if years when I’ve tried sorting my debts. Will settlements affect my chances or will I need to pay them off fully? Or will they fall off my credit record? I honestly don’t know what to do for the best and… Read more »

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