Bottom line: Interest-only mortgages may not be as bad as they seem as long as they are used in the right way.
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:
First off, here are the assumptions I made:
1. A $200,000 30-year fixed mortgage with a 15-year interest only period and a $200,000 30-year fixed mortgage. Both mortgages carry a 6.30% interest rate.
2. The payment on the interest-only mortgage will start out at $1,050 per month for the first 15 years (180 months) and then will jump to $1,720 beginning with payment number 181.
3. I have assumed that the $1,720 payment is affordable in BOTH scenarios.
4. Since I assumed that the $1,720 payment was affordable in both scenarios, I also assumed that the difference in payments would be invested at a 10% annual rate of return. The payment differences were calculated at follows:
Interest-only mortgage: $1,720 – $1,050 = $670
With the IO mortgage, $670 per month will be invested throughout the interest-only period.
30-year fixed mortgage: $1,720 – $1,238 = $482
5. I assumed the value of the house will increase at 3% per year.
6. The annual net worth is figured using the investment account value plus the value of the house minus the outstanding mortgage balance.
7. I left out all tax implications. Why? Because there’s so many different scenarios involving taxes it’s nearly impossible to address them. So, you’ll need to run the numbers yourself BEFORE you choose a mortgage.
Okay, here are the numbers:
It all boils down to allocation of funds. IF mortgage rates are low enough, it might make sense to invest your money elsewhere. Remember that this scenario will ONLY have a chance work if you invest the difference! There’s also no guarantee that you will be able to get a 10% rate of return on your investments.
Interest-only mortgages are not without risks. Remember that the low payment won’t last forever and once it ends, you’ll face a payment that is likely to be over 50% higher. Your house could decrease in value, potentially leaving you in a negative amortization should you need to refinance.