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How an Interest-Only Mortgage Works

By JLP | March 29, 2007

Let’s say you want to buy a house and will need to finance it with a $200,000 mortgage. You meet with a mortgage broker and they show you two loans: a 30-year fixed rate mortgage at 6.30% and a 30-year fixed rate mortgage with an interest-only period of 15 years (also at 6.30%). How do you compare these two mortgages?

30-Year Fixed-Rate Mortgage

Using this calculator, you can see that the payment on a $200,000, 30-year fixed rate mortgage at 6.30% would be $1,238 (or $1,237.95 to be exact). Beginning with the very first payment, a very small portion of the payment will go towards the principal of the loan and a very BIG portion of the payment will go to pay interest as the graphic below shows:

Notice that the beginning balance for the second month is smaller than the beginning balance from the previous month. That’s because a portion of your payment is going towards the principal. As you continue to pay on your mortgage, the percentage of each payment that goes towards interest will decrease while the amount going towards the principal will increase. Towards the end of the mortgage term, most of the payment will go towards principal and very little will go towards interest. For more on how the math of a mortgage works, see this post I wrote last year.

Pretty simple stuff. Now let’s look at an interest-only mortgage.

30-Year Fixed Rate Mortgage With a 15-Year Interest-Only Period

An interest-only loan is essentially two loans rolled into one. For example: a 30-year fixed rate mortgage with a 15-year interest-only period works out to two 15-year loans. As we calculated in the first example, the interest amount on the first payment is $1,050. With an interest-only mortgage, your initial payment would be $1,050, which is $187.95 smaller than the traditional payment:

Notice that because all you are paying is interest, your loan amount stays the same. In other words, you pay each month but you don’t make any progress on actually paying off the loan. This would continue for 180 payments (15 years). At the end of 15 years, you will still owe $200,000 on your mortgage. In order to pay off that mortgage in the next 15 years, you will have to pay substantially more each month. How much more? Well, you can calculate it yourself using this calculator. For the input, use 15 years, 6.30% interest rate, $200,000 for amount borrowed. You should get $1,720 ($1,720.30 to be precise) or $670 MORE per month! You’ll then have to pay $1,720 per month for the next 15 years (180 months).

What About Equity?

Equity in a house comes from two sources:

1. The amount of each payment that goes towards principal. At the end of 15 years, the traditional mortgage would have built up an equity position of $56,078. You would have built no equity position from payments with the IO mortgage.

2. The appreciation in the value of the home. In the example, if the home appreciates at 3% per year, at the end of 15 years, it will be worth $311,594.

With the traditional 30-year fixed mortgage, at the end of 15 years, you will have an equity position of $167,672 [$56,078 equity built up in the mortgage + $111,594 appreciation in the value of the home). With the IO mortgage, your equity-position will just be the increase in the value of the home ($111,594). NOTE: There’s NO GUARANTEE that the house will appreciate in value. Some areas of the U.S. have experienced price declines, which put some people in negative equity positions (not a good thing!).

At the End of 30 Years

As you can see from the graphic below, the interest-only mortgage carries with it significantly more in interest charges. However, this doesn’t tell the whole story as it leaves out the potential growth in the payment difference and the tax deductibility of the interest (more on this in a future post).

At first glance, the IO mortgage does not appear to be that great of a deal. You’re only “saving” $187 per month and that only lasts for a while. If you can’t afford the $187 difference, should you be buying the house? Good question.

More on this later…

Topics: Budgeting, Calculators, Financial Math Basics, Housing Market, Mortgages | 52 Comments »


52 Responses to “How an Interest-Only Mortgage Works”

  1. Bob Says:
    March 29th, 2007 at 11:50 am

    But what if you took the $187 and invested every month in a bank account paying the current interest of 5%.At the end of 15 years you would have around 50K approximately.Infact if one took a little more risk and invested in the stock market you could actually do better than the 50K.

  2. JLP Says:
    March 29th, 2007 at 11:58 am

    Bob,

    Yeah, I thought about that. That’s the topic of a follow-up post.

  3. sam Says:
    March 29th, 2007 at 12:30 pm

    Seems to me that an interest only loan is basically similar to renting. But that’s just me.

  4. philskaren Says:
    March 29th, 2007 at 1:02 pm

    possibly, like renting, but with an opportunity for appreciation to kick in and an investment of the savings? i am very interested in your follow up JLP.

  5. db Says:
    March 29th, 2007 at 1:38 pm

    You may do better by investing that $187, but how much better? Not to mention that you could easily lose value in that investment if you pick badly or simply hit the wrong time in the market? Whereas if you pay that $187 and forego investing, you are for sure reducing your debt position and most likely increasing your equity.

    Everybody wants to find an edge, but want to overlook how simple it can all be.

    JLP, I’m interested in your follow-up article.

  6. yu now who Says:
    March 29th, 2007 at 1:52 pm

    What are the tax implications. I’m not sure about everywhere, but here mortgage interest is tax deductible. That is another variable to throw into the decision making process. How would interest only mortgages (if you can call them mortgagrs) be classified by the IRS, mortgages or consumer debt?

  7. The Digerati Life Says:
    March 29th, 2007 at 2:00 pm

    I like the examples here. Someone made the comment that monetarily, interest only loans are similar to renting. I suppose so, but I had some friends who did interest only loans and as time went on they were able to refinance to something they were eventually comfortable with. So that worked out for them though they started off risky.

  8. Don Says:
    March 29th, 2007 at 3:30 pm

    Even if the mortgage tax isn’t deductible, the income on your $187 investments will probably be.

  9. Gaming The Credit System Says:
    March 29th, 2007 at 4:41 pm

    I’m also interested to see your follow-up and particularly want to see you discuss inflation.

    According to the Inflation Calculator (http://www.westegg.com/inflation/ ), $1230 in 1991 dollars (15 years ago) is equivalent to $1841 in 2006 dollars. This is $120 less than the $1720 payment which would start in 2006. Based on this initial analysis, it seems to me that interest-only for 15 years might not be such a bad deal.

    I see it as sort of a 15-year “option to buy” a house that fixes the price for 15 years. It’s like saying “I’ll buy this house for $200,000 in 15 years with a required 15-year mortgage at that point, and any appreciation during the initial 15 years is mine to keep. In return for this option, I have to pay $1050 a month to rent it for the first 15 years.” Which seems to me to be pretty powerful…. kind of like infinite leverage! And it’s even better when you consider that the interest-only payment is probably less than what you’d pay in rent for a comparable house.

  10. UK Home Mortgages Says:
    March 29th, 2007 at 5:39 pm

    This is a great explanation and helps me understand the interest only home mortgage better..thanks!

  11. Steve Leung from 1SiliconValley.com Says:
    March 29th, 2007 at 6:36 pm

    Great analysis. A lot of people think “interest-only” and immediately recoil, without having looked at the opportunity cost.

    For people who are financially disciplined, the ability to *choose* whether they put their money into equity or another investment vehicle can be very beneficial.

    Many lenders will provide interest-only and P&I loans at the same price.

  12. Steve Leung from 1SiliconValley.com Says:
    March 29th, 2007 at 6:46 pm

    db: I think you’re right about the possibility of downside on your alternate investments, but there’s another argument that there’s additional freedom and liquidity :-)

  13. Miguel Says:
    March 29th, 2007 at 6:47 pm

    If and when I refinance, I will definately look into interest-only. I think this would work well for me because my income is extremely lumpy – though the average is fairly predictable, the dollar amount can swing wildly from year to year. Having the freedom to decide exactly how much to apply to principal each year would work well. And I am pretty good at setting targets and sticking to them – so if I determine that I should reduce principal to X amount by Y years, we are disciplined enough to do it.

  14. db Says:
    March 29th, 2007 at 7:15 pm

    What additional freedom and liquidity? I’m not gaining anything equity-wise with an interest-only mortgage. You want freedomn and liquidity? Buckle down and pay that sucker off in 5 or 10 years. Then you have the home free and clear, except for property taxes and upkeep.

    I imagine a lot of those people trading up out of their interest only loans look really great on paper, but don’t have a solid positive net worth either.

    No thanks — I had a chance at a zero-down, interest-only loan and passed it up.

    db

  15. Esko Says:
    March 29th, 2007 at 7:31 pm

    When thinking about financing a home with an interest-only mortgage, give yourself an option by looking at loans with no prepayment penalty. If you decide later on to pay down principal and thus build equity that way, it can be done by just sending in a separate check for the desired amount. Also, if you do that, follow up on it to make certain the lender applies the money for the intended purpose.

  16. Steve Leung from 1SiliconValley.com Says:
    March 29th, 2007 at 7:32 pm

    Actually, db, that’s not the point I’m trying to make :-) I’ve actually written several articles about why it’s good to put down payments on houses and pay principal.

    What I’m saying is your house isn’t a liquid investment. You can’t just pull cash out of your home equity (without a mortgage or HELOC).

    If you put $800,000 into your house to buy it “free and clear” but you don’t have money in the bank should unforeseen circumstances occur, are you more or less free? You’d be forced into getting a loan.

    I’m not advocating everyone go for interest-only loans, but they’re an extremely useful tool because at equal interest rates, you get to choose whether to pay-down your house, invest the money, or deal with financial emergencies.

    If the person choosing has too many financial emergencies, then an interest-only loan may not be for them.

    One of the points in this article is “What is equity?” It’s money. At equal costs and with financial discipline, some would rather be able to choose where it goes than not.

  17. Gaming The Credit System Says:
    March 29th, 2007 at 10:37 pm

    oops, meant to say $120 more…. the point being… well, maybe it’s easier to look at it the other way around. Assuming inflation for the next 15 years is the same as the previous 15 years, the $1720 payment in 15 years will be the same as a $1156.07 payment today. Which is less than the $1,238 payment would have been the whole time. Of course, the $1238 payment would have declined to being the equivalent of today’s $832, so maybe it’s a wash, although inflation always favors the borrower, so I think it favors the interest-only loan more than the standard loan. Maybe not enough to make a difference. But… it’s worth at least thinking about. Sorry, I tend to get off track with these things.

  18. db Says:
    March 30th, 2007 at 12:28 am

    @Steve:
    ell I agree wholeheartedly that your house isn’t a liquid investment, and it’s not intended to be used as a savings account. But I don’t see why that makes this a smart deal. The whole point of paying down/off the house is to free money so you can then save and build wealth. Wouldn’t it be better to face an emergency with a fat bank account and a reasonable mortgage?

    What I see here is a lot of “what ifs” and other justifications for buying a house that you probably can’t afford. If you can’t afford a house without an interest-only mortgage, or if you favor an interest-only mortgage because you are that worried about situations where you might need the extra cash that you’d otherwise put into the mortgage, can you really afford that house? Really???

    I think people tend to forget that there is a viable option to interest-only mortgage or regular mortgage — NO mortgage (either paid off or as a non-homeowner). It’s all part of our “I want it now” culture that we’ll tinker with something like an interest-only mortgage where we are basically treading water for the first 15 years. How does this build wealth?

    Final question: What is going to hold the person to being disciplined enough that they will actually invest their extra $187/mo. (or whatever) that they are freeing up with their interest-only mortgage?

    db

  19. Madame X Says:
    March 30th, 2007 at 7:41 am

    Very interesting post and comments. One of the assumptions people seem to make is that anyone who takes out an income-only mortgage will buy a house that maxes it out so that the monthly payment in the initial period is the maximum they can possibly afford. That is where you might run into trouble. But if you really are saving money and investing it diligently, I can see how this kind of mortgage could be a smart choice. Unfortunately, no one seems to market these mortgages to the people who are best in the position to use them– instead it seems like they are pushed at people who might otherwise not be able to afford a mortgage at all, so they’ll just end up paying more interest and building no equity, and then drowning when the payments go up.

  20. tinyhands Says:
    March 30th, 2007 at 8:57 am

    Responding to those who think this is like renting:
    You’ve missed the equity stake. If the house appreciates in value, your equity in the property is the appreciation. This is not the case in renting. But don’t ignore the downside. It IS possible to have negative equity, should the property devalue.

    That said, if building equity is important to you, you’ll build equity in a traditional mortgage faster. Equity in property may not be AS liquid as cash/investments, but it is an asset.

  21. Miguel Says:
    March 30th, 2007 at 11:37 am

    db,

    I recognize the I-O mortgage could be dangerous in the wrong hands – for somebody who may be stretching the affordability criteria.

    But, I have substantial equity in my home already. And have investment funds enough to pay off mortgage in a worst case scenario.

    The I-O mortgage is purely a financial tool I would consider.

  22. db Says:
    March 30th, 2007 at 7:12 pm

    Why would you be buying a home and not have one of your goals be equity?

  23. Money Articles and Personal Finance Picks for the End of March, 2007 » Silicon Valley Blog About Money Says:
    March 31st, 2007 at 9:11 am

    […] All Financial Matters shows us How an Interest-Only Mortgage Works by providing some mortgage examples. […]

  24. Foobarista Says:
    March 31st, 2007 at 3:04 pm

    There are two general “classes” of mortgages: those that let you buy a house before you’ve saved up the money to buy it outright, and those that are financial instruments for investing.

    This type of mortgage is definitely the latter, and it’s perfect for an investor wanting to buy a house for cashflow. That $187/month may be the difference between the investment being solidly positive or not. And an investor will probably sell the place – or refinance it – before the 2nd 15 year “paydown” period starts since much of the depreciation would be done by then.

  25. fivecentnickel.com Says:
    March 31st, 2007 at 9:40 pm

    Weekly Roundup – 03/30/07

    Here’s a quick look at some of the articles that caught my eye over the past week…

    Flexo talks about ten ways to spend your tax refund for fun.
    Jim reviewed the Chase Freedom reward credit card.
    FMF talks about a simple move that could save you a…

  26. Mighty Bargain Hunter » Roundup for week of 25 March 2007 Says:
    April 1st, 2007 at 12:08 am

    […] All Financial Matters explains how an interest-only mortgage works.  It’s a good article with lots of insightful comments.  At first glance one might think that mortgages with an interest-only term are sucker plays (lower payment, higher overall cost) but there are other facets like inflation, difference in disposable income, length of stay in the house, etc. […]

  27. Andrew Says:
    April 1st, 2007 at 1:51 pm

    IO’s can be a very powerful option for the right situations…

    If you are a disciplined and diligent saver/investor, there are many reasons to do the IO mortgage. Example of a 45 year old: Instead of just saving/investing the $187/month with a IO mortgage, why not put it into a tax-deferred and potentially tax-free account (Read: Roth IRA). Invest that $187/month in the Roth IRA and at 6.3% return over 15 years you have your $56,000 that would have been built up in equity in the house using a traditional mortgage. At this point you would be 60 years old and could lower your mortgage debt by $56,000 without paying taxes because it’s a Roth. Secondly, because you weren’t paying off principal in the house you got more interest to deduct. Since it is a Roth IRA and you don’t pay taxes on the withdrawals in this example we really don’t need to make 6.3% each year either for the $187/month investment…it would be (6.3% with .215% federal and state taxes in MN = 4.9455% break-even). Finally, even a balanced/growth fund should return over 6.3% (worst case 4.9455%) over ANY 15 year period which would make IO even more attractive.

    And what if you sold the house at age 60 after 15 years and wanted to use the proceeds for retirement income?: Let’s say it had appreciated $100,000 and you had equity of $56,000 in the house from the traditional mortgage ($156,000 total). This $156k is now a full taxable investment and nowhere nearly as effective as an investment as an IO where you would have $100k taxable and $56,000 still in a Roth IRA making tax-deferred and tax-free withdrawals.

    With that being said, you have to be a good saver, be able to invest in a Roth, and have a good idea you are going to be in the house for a long time.

    And you have to able to qualify for Roth IRA limitations which can be a problem for many. My $.02.

  28. db Says:
    April 1st, 2007 at 3:06 pm

    @Andrew:

    Yes, but then you’ve cannibalized your Roth IRA (Question: that Roth IRA is supposed to be a RETIREMENT fund, right? It’s supposed to be a fund to help you avoid eating Alpo and relying on Medicare when you’re 80. Not a “pay the mortgage when I’m 60 so I can think I gamed the system” fund.)

    Let me just reiterate: you really think you are coming out ahead by taking an interest only loan so you can save the money in a Roth IRA, so that down the road you’ll remove that money you saved from the Roth IRA to pay the principal you’ve been avoiding? That makes no sense.

    And you’ve paid more in interest than you may have needed to — forget paying down the principal, what about all that interest money you threw to the wind for 15 years? You never recover interest paid (and please don’t try to impress me with the tax deduction — you can’t deduct the full amount of interest paid by a long shot)

    Isn’t that why people say not to rent? To avoid throwing money to the wind?

    I still don’t see a compelling advantage to this. If you can only afford the property via an interest-only loan you shouldn’t be buying the property. If you can afford a traditional loan, then why monkey around with this?

    Why is this whole concept better than paying a traditional mortgage, and (heaven forbid) even paying it off a little early?

    Why?

    db

  29. Debt Blitzkrieg » Blog Archive » Interest-only mortgages and why they scare me as much as my student loan Says:
    April 1st, 2007 at 3:46 pm

    […] A recent discussion at AllFinancialMatters about interest-only mortgages has left me a little itchy under the collar. You can read my sage wisdom (or maybe they are lunatic ravings…) in the comments. […]

  30. Andew Says:
    April 1st, 2007 at 6:49 pm

    I agree that you don’t want to use the Roth IRA to pay down the mortgage at 60, but it could be done.

    And realistically, in the example at age 60 you wouldn’t cash out your Roth IRA, you would keep it invested. However, if you did the traditional mortgage and didn’t have the ability to save the full Roth IRA each year, it gives another reason for the IO mortgage.

    With the traditional mortgage you would have $56,000 equity in paid down principal but you missed out on full Roth IRA contributions each year. With the interest only mortgage you could have fully funded your Roth IRA each year and have that $56,000 after 15 years….and that’s assuming just a 6.3% return which, even conservatively, is on the low end over any 15 year stretch that comes to mind.

    In my eyes, a house is going to appreciate or depreciate regardless of whether you have it fully paid off or none of it paid off. Additionally, the majority of the time – 15 year periods – your house will appreciate in value and equities will outperform 6.3%. More advantages to IO mortgages.

    I personally have a traditional mortgage (30 yr) and can’t contribute to a Roth but I can see the merits of IO mortgages for the right situtation.

  31. Miguel Says:
    April 2nd, 2007 at 6:29 am

    db,

    Sorry about the lapse in responding. Your comment: “Why would you be buying a home and not have one of your goals be equity?” makes no sense to me. Why do you assign the worst possible motives to anyone who would consider an I-O mortgage?

    For example:

    – Suppose I just want the flexibility to pay down the mortgage at irregular intervals because my income is lumpy.
    – Or suppose I anticipate being able to repay the mortgage someday from non-retirement funds.
    – Or suppose I might actually decide to carry a mortgage forever until I sell the home.
    – Or perhaps I have business and investment opptys where I think the returns more than offset the interest costs of carrying a higher mortgage balance.
    – Or perhaps I am in a high enough tax bracker that the mortgage int ded is very significant (lowering the real cost of borrowing to a nominal figure). I mean, basically, if you could borrow at 3% net interest cost, isn’t that something you’d do all day long?
    – And to top it off, suppose you already have over $1mm equity in your home. Would you really care about creating even more home equity? Diversification might be a better strategy.

    Now, supposing all of the above applied. I don’t see how you could deny that an I-O loan might not be a bad idea. Maybe it’s not for everyone, but clearly there are situations where it might make sense.

  32. db Says:
    April 2nd, 2007 at 7:39 am

    @Miguel:

    To your points:

    1. OK — if the only way you can safely take on a mortgage due to irregular income is to take this interest-only loan, and you’ll be making lumpy payments all along to pay the stupid thing off, then go ahead and do it. If your income is that spotty though maybe you should save up for a while to even it out instead of taking on a mortgage.

    2. NO — if you are taking on a mortgage now, you should not be planning on “repaying the mortgage someday from non-retirement funds”, you should be repaying the mortgage NOW. Sorry, but that sounds to me like you are just deferring an expense to tomorrow — if this is the only way you can afford the mortgage then again perhaps you should not be getting the mortgage at all. If you can pay the mortgage then pay the thing NOW.

    3. WELL OK — if what you really want to do is basically pay interest until you sell the home, thus building no equity yourself — and thus totally relying on the home appreciating in value, then be my guest. Wouldn’t want to be doing that and trying to unload the house in today’s market. I don’t get the brilliance of this idea.

    4. Perhaps this is legitimate. I don’t get the whole business and investments opportunities thing so I won’t poke at it much. Personally I don’t like real estate as an investment.

    5. Manuel — 0% net interest cost of a paid off home is infinately preferable to me than borrowing at 3% net interest cost. NO I would not do this all day long — I would be spending every day figuring out how I could pay off the da$%#$@ interest that I was slavishly servicing. (P.S. – I’m not exactly in a low tax bracket myself.)

    6. NO — I can’t wrap my head around having over $1mm equity in my home anyway, that sort of thing just isn’t in my view — but even so I fail to see how diversification (I presume you mean of investments) is served by carrying an interest-only mortgage. If I had the sort of wealth where I could be affording a home worth that large, I should have the sort of cash flow where taking on a mortgage isn’t going to make or break my ability to have other funds to invest elsewhere. If I don’t, then is my net worth really tangible or is it a figment on paper?

    Basically your argument just drives more and more to the point that the interest-only mortgage is a great idea for somebody with high net worth and lots of investment properties — say, a big time flipper. Great. (I don’t have any love for flippers — I fail to care whether the system is set up to favor what they do.) Is that who is really using this vehicle? Probably so, but I think the sort of person meeting ALL of your criteria is a pretty rare bird.

    I think this interest-only mortgage is being pushed at those least able to afford it — the guy at the lower end of the totem pole who really can’t afford a house but desperately wants it. I think that’s a bit crooked on the part of the lenders — it allows them to take on a customer who really shouldn’t be a customer at this point.

    And I really don’t think that if Warren Buffet were sitting here with us that he’d favor an approach where a person dodges their responsibility to pay their mortgage in a timely manner in favor of freeing up “cash flow” to “invest”. (Get it? That’s what I think an interest-only mortgage is — dodging one’s responsibility to pay on an outstanding debt.)

    If I’m wrong then I’d gladly buy Warren’s lunch and daily Coke.

  33. AllFinancialMatters » Blog Archive » Interest-Only Mortgage Update Says:
    April 2nd, 2007 at 12:45 pm

    […] There was some pretty good discussion going on with my previous post on interest-only mortgages. As promised I have taken a look at the numbers. Here’s what I found out: […]

  34. Miguel Says:
    April 2nd, 2007 at 2:04 pm

    db,

    Well, I must say one thing: You are consistent in your position. But, it sounds to me like it simply amounts to a DEBT IS BAD mantra. This bit about “dodging one’s responsibility to pay down debt” simply makes no sense to me. There is no legal or moral obligation to repay debt until it comes due.

    Maybe what you are trying to say is that if you intentionally put yourself in a position to potentially default on the debt, then that amounts to unethical behavior, but it’s still a stretch when we are talking about something that comes due in 30 years and is ultimately backed by the value of the property. And it’s not as though lenders don’t have some “ethical” obligation to properly screen people.

    Anyhow – Bottom-line, you have not said anything to dissuade me from considering the I-O mortgage. And like I said, I already have the funds to repay the mortgage, so I wouldn’t be incurring any moral hazard. For some people these products are finacial tools that can be used to maximize and enhance one’s balance sheet.

    Guess, we’ll have to agree to disagree. Where I will agree is that there is much danger in marketing alternative mortgage products to the wrong people. But the I-O mortgage is only the tip of the iceberg on that issue. Products that permit negative amortization, or permit minimal down payments, or finance +100% LTV, or feature teaser rates that explode in a couple years – that is the stuff you should be looking out for because it is by design intended to be marketed to weaker credit borrowers.

  35. JLP Says:
    April 2nd, 2007 at 2:26 pm

    All,

    Great discussion.

    There’s no doubt that an IO in the wrong hands can spell disaster. But, the same can be said for ANY loan (car loans, credit cards, etc.). I think it is important to know all the options before making a decision.

  36. db Says:
    April 2nd, 2007 at 2:28 pm

    @miguel.

    Yes. Debt is bad.

  37. JLP Says:
    April 2nd, 2007 at 2:39 pm

    Yes. Debt is bad.

    db,

    I don’t think I would go that far. Sure, some debt is bad but mortgage debt can be good debt.

  38. Miguel Says:
    April 2nd, 2007 at 3:47 pm

    Ways in which debt has helped me:

    1) I used debt to pay for an education. This positioned me to gain entry to careers which allowed me to repay that debt within a few years.

    2) As I was establishing myself as an adult, CC Debt has helped me through some tough cash shortgages (though admittedly it also helped create some too). Hey – fire can keep you warm and it can burn you too.

    3) Debt allowed me to purchase my first home – a co-op apt in NYC. My $23K down payment allowed me to acquire property which eventually yielded $350K gain.

    4) The money from that gain, combined with other savings, a mortgage, and construction loans allowed me to acquire a run-down brownstone which wife and I restored and converted to a multi-unit property both to housing us, and provide rental income to pay a substantial portion of the monthly mortgage. Equity in r.e. is now well into 7-figures.

    I could go on. Debt finances inventory for my spouse’s business, debt allows us to make opportunistic investments, etc. Being somebody who basically started our with zero assets and no financial help, the careful use of debt has permitted me to greatly leverage my ability to generate wealth.

    You shouldn’t be afraid of debt – though you should respect it – both for it’s destructive power, as well as it’s usefulness. If you don’t need debt, then more power to you. But, don’t for a second believe that debt is inherently bad.

  39. Miguel Says:
    April 2nd, 2007 at 3:51 pm

    Uh – I hate typos. Here’s the corrected version:

    Ways in which debt has helped me:

    1) I used debt to pay for an education. This positioned me to gain entry to careers which allowed me to repay that debt within a few years.

    2) As I was establishing myself as an adult, CC Debt helped me through some tough cash shortages (though admittedly it also helped create some too). Hey – fire can keep you warm and it can burn you too.

    3) Debt allowed me to purchase my first home – a co-op apt in NYC. My $23K down payment allowed me to acquire property which eventually yielded $350K gain.

    4) The money from that gain, combined with other savings, a mortgage, and construction loans allowed me to acquire a run-down brownstone which wife and I restored and converted to a multi-unit property both to house us, and provide rental income to pay a substantial portion of the monthly mortgage. Equity in r.e. is now well into 7-figures.

    I could go on. Debt finances inventory for my spouse’s business, debt allows us to make opportunistic investments, etc. Being somebody who basically started out with zero assets and no financial help, the careful use of debt has permitted me to greatly leverage my ability to generate wealth.

    You shouldn’t be afraid of debt – though you should respect it – both for it’s destructive power, as well as it’s usefulness. If you don’t need debt, then more power to you. But, don’t for a second believe that debt is inherently bad.

  40. Miguel Says:
    April 2nd, 2007 at 3:53 pm

    And by the way, I think Warren Buffet would tell you exactly what I just told you.

  41. Andew Says:
    April 2nd, 2007 at 4:25 pm

    @Miguel:

    Great points. It can be used for the right situations. I couldn’t agree more.

    Here’s a question sure to make DB unhappy:

    If you have a house fully paid off of let’s say $200,000 and you are still working and far from retirement, does it make sense to pull the equity out and invest for the long term at higher appreciation?

    This is the idea behind the book, Missed Fortune (on Amazon), is:

    * You shouldn’t pre-pay your mortgage
    * Don’t expect your 401Ks and IRAs to cover retirement
    * You can (and should) buy a home with no money down
    * and more!

    What do you think?

  42. Miguel Says:
    April 2nd, 2007 at 4:56 pm

    @Andrew – Thanks, but with questions like that there are so many personal variables, that it just doesn’t make sense to start trying to recommend a course of action. I really have no idea if pulling equity out in that situation is a good or bad idea – which is why I’m always suspicious of books and/or methodologies that offer a catch-all, hard and fast solution to personal finance (not that I’ve read Missed Fortune).

    In the real world, your example character might be really uninformed as an investor, blow the money on lop-sided bets, and be in much worst shape after a year. On the other hand, he (or she) might be really handy and uses a home equity loan to buy a couple of run down rental properties in an area they are very familiar with, put in some sweat equity, and start generating alternate income sources that might help them retire some day. Everybody has things they are pretty good at, and totally suck at, and how you approach building wealth has everything to do with your own personal weaknesses and strengths, plus all the other things surrouding your family, job, health, interests, etc.

    I just happen to be good at certain things and figured out how to apply those things to creating value – using debt as one of my tools.

  43. db Says:
    April 2nd, 2007 at 5:17 pm

    @Andrew:

    No, it doesn’t make db unhappy. However db won’t touch that concept with a 10-ft pole (except the part about not expecting a 401(k) or IRA to cover retirement). I’ll let others monkey around with the Missed Fortune stuff. As for me, I will at the very least have a 10-20% downpayment whenever I buy a home, and I will be paying it off in 15 years or less. Otherwise I’ll be a renter.

    @miguel:

    I relent and take back my flippant “debt is bad” comment. Yes, debt can be useful in certain circumstances. I’ll reframe it like this: Debt is dangerous, it’s to be approached with caution, and you should always keep in mind that neat mathematical rationalizations of how it should all work to your favor could easily turn out to have been mistaken.

    I too benefitted from debt for school (monetarily it’s been decent; the happiness factor that results is another story — the payoff hasn’t extended to personal fulfillment). I do not have the money to participate in the real estate game, and credit cards are more a curse than a blessing.

    That said, you’ll never convince me that paying on an interest only mortgage has significant enough benefit to warrant it, at least not for a primary residence. The rationale behind investment properties is outside my interest — do whatever you want there (though I do have a grudge at this particular sector for driving property values up to ridiculous levels).

    I’ve said about as much on this topic as I have to say.

    db

  44. adamH Says:
    April 3rd, 2007 at 11:43 am

    wow, great discussion on this topic, too bad it took me a week to catch up on my RSS feeds. I get paid quarterly bonuses, so for me, an I-O mortgage makes a lot of sense: keep the monthly payment as low as possible (without digging myself into a deeper hole like some of those reverse-amortizing loans that helped kill the sub prime lenders) and pay down equity with my bonuses. To me, I view it as taking the equity part of a fixed rate mortgage as chunks of 3 months that i make payments for every quarter. But, to me, I-O loans make sense only if you know you have ‘hills’ in your salary (like I do) or your pay is variable (comisions, etc) and you have enough extra money lying around to get you through some sparse time. Obviously, I am only looking at this through a consumers point of view who is buying a place to live in themselves, and I think some of the other reasons listed above have validity to them.

  45. elpidiovaldez Says:
    May 9th, 2007 at 10:39 pm

    ok, I see value on the interest only loan, as long as is fixed rate, and doesn’t have a prepayment penalty.

    Say for example you want to buy a second house to move out of your current house, keep your current house and rent it out.

    Ok, I would take a cash out loan on the first house just enough to put 20% down on the second house (plus a little emergency fund) and an interest only loan on the second house to have flexibility on the cash flow.

    The first house (old) presumably will be paid by the renters, so the interest only payment allows for better cash flow. Rent doesn’t have to be too high to cover a full amortized loan.

    On the second loan, I can accelerate the payments, as long as there is not better place where to put the money at the time.

    Eventually when the 10 years interest only expires, there will be enough equity in the first house (barring something really drastic and never seen before) just because the appreciation.

    At that time, there are decisions to make.

    1. Sell the first house and invest the money.
    2. Continue renting the house, granted that at the time rent is enough to cover the increase interest only payment.
    3. Refi the first house, take out cash (to the level that rent covers costs) and use that cash to make a sizable payment on the loan for the second house, thus in fact having the ability to reduce the payment for the rest of the life of the loan.

    My point is that interest-only payments are a good tool. The bad thing is when somebody buy a McMansion and can barely afford the IO payment. That is a recipe for disaster specially because people that buy McMansions that cannot afford also have the tendency to take “no cost” cash out refi to keep a life style that cannot afford.

    In my opinion there are not good or bad loans, but there are smart and no so smart borrowers. That is where the problem lies.

  46. AllFinancialMatters » Blog Archive » The Top 5 Reasons to Pay Off Your Mortgage? Says:
    May 14th, 2007 at 10:30 am

    […] How an Interest-Only Mortgage Works […]

  47. Michael Ivanov Says:
    July 5th, 2007 at 3:59 pm

    There are so many things that must be taken into consideration and depending on what they are(appreciation, depreciation, equity already vested in the property, financial situation, and others) an I/O can be an incredible money saving option or a tool for disaster. Just my 2 cents.

    – Michael
    http://www.gotoloanguru.com

  48. Earle Says:
    July 31st, 2007 at 1:19 pm

    I have an IO payment of 1,600 on a rental property in an area not likely to appreciate very much. It brings in an extra 1,400 per month. I’ve been putting that extra 1,400 towards the principal.

    Would I be better served putting this extra 1,400 in a mutual fund/cd/stocks of some sort, and if so, what return would I need on the investment to justify not paying down my principal?

    Thanks to any who have an opinion/experience on this.

  49. Earle Says:
    July 31st, 2007 at 1:22 pm

    Forgot to mention- my interest rate is 7.5%.

  50. leeanne Says:
    August 14th, 2007 at 9:49 pm

    yes, there are people who are using I/Os to get into houses they can’t afford. but perhaps that says something about the out of control real estate market of the past 2 years that is only now beginning to slow down as shady practices by everyone from lenders to builders to buyers is being exposed. i write this from one of the highest cost of living areas in the country (DC Metro), where you can’t buy a house for under 400K, and the possibility of renting even a one bedroom apartment for under $1500 per month is slim (unless you don’t mind dodging stray bullets in your living room). Have incomes risen as fast? I don’t think I need to answer that. People feel forced to make a decision between an apartment they can’t afford or a property they can’t afford. Which would you choose? “Just pay that sucker off” is not an option for an increasing number of Americans.

  51. Hit counter Says:
    January 26th, 2008 at 12:48 am

    Mony is mony and all we need is mony

  52. Hoodia Gordonii Says:
    February 9th, 2008 at 12:07 am

    Nothing can stop me by posting these comments.

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