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Interest-Only Mortgage Update

By JLP | April 2, 2007

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.

Topics: Financial Math Basics, Mortgages | 19 Comments »


19 Responses to “Interest-Only Mortgage Update”

  1. db Says:
    April 2nd, 2007 at 5:22 pm

    Well.

    On the other hand it would be interesting to see where you’d be if you paid off that mortgage in 25, 20, 15, 10 and 5 years instead of either 30 year option, and then invested the full payment each month of the remaining 30 years.

    db

  2. Jerry Says:
    April 2nd, 2007 at 6:30 pm

    Great explanation. Bottom line: manage your mortgage to be successful.

    Jerry

  3. lorax Says:
    April 2nd, 2007 at 6:42 pm

    > difference in payments would be invested at a 10% annual rate of return.

    Whoa… there’s going to be quite a bit of risk in that 10% return, even if you do get it.

    IMHO, this is an apples and oranges comparison. The mortgage is sort of a reverse bond, so I think you need to compare to a bond. You could pay down the mortgage, take out a call option on SPY and get similar risk. (Or, as many like to think about it, you’re buying those 10% return stocks on margin.)

  4. JLP Says:
    April 2nd, 2007 at 8:19 pm

    lorax,

    In the short run, sure you’ll have some volatility. However, over the long run, you’ll most likely do fine.

    I have to disagree with you that this is an apples and oranges comparison. Rather, it’s an allocation of funds question. Everyone should consider the opportunity cost for each decision they make. I’m not going to say which way is the best way. My goal is to throw the information out there and let each person decide for themselves.

  5. Joe Says:
    April 2nd, 2007 at 9:34 pm

    Your scenerio is unrealistic in the sense that the money saved on payments will be reinvested in the stock market–an interest only loan is about freeing money up to spend nothing more–it is about affordability. The comparison is worthwhile though.

  6. Dr. Housing Bubble Says:
    April 3rd, 2007 at 10:31 am

    Great analysis of interest only mortgage. Unfortunately the market is flooded with option-only mortgages and negative amortization mortgages, especially in the sub-prime market.

    It would be great to see an option-only mortgage analysis.

  7. pf101 Says:
    April 3rd, 2007 at 11:03 am

    I agree, that IO loans are a great option for people that use them correctly. I personally wouldn’t invest the money in the market, though that would probably be the most financially agressive thing to do. What I would do would be to have the IO loan with the low IO payment but continue to pay as if it was the 30-year loan. This would substantially reduce the length of my mortgage.

    IO loans were initially developed so people with unsteady income (sales people, etc.) could have a low fixed rate which would allow them to make minimum payment and also catch-up payments throughout the term of the loan. This would keep them on track for paying it off in 30 years (or fewer) and wouldn’t be such a shock to the system when it reverted after the IO portion finished.

    It was NOT intended to do what it has been used for recently (sorry commenter Joe) which is to let people get into houses they can’t afford with traditional mortgages. All this new use has done is guarantee that when it comes time to adjust a lot of people are going to be in trouble and will have to sell (if they aren’t upsidedown on their mortgage). It’s like a credit card. If you don’t make more than the minimum payment you’re going to get in trouble.

  8. Chris Thomas Says:
    April 3rd, 2007 at 1:41 pm

    What’s your take on this interest-only loan? http://pourout.wordpress.com/2007/04/03/news-of-the-stupid-variety/

  9. maxconfus Says:
    April 3rd, 2007 at 2:01 pm

    interest only mortgages are a legitimate tool despite what the msm says. For instance, you have a family and live in a house. Currently you are a dental assistant. You want to go to dental school but not leave your house. An interest only mortgage may be an option so that your payment was lower while in school and then when out of school your pay is higher so you can afford the higher mortgage payment. Where interest only mortgages are bad is when people who can not be approved for a fixed loan of $100K, for instance, because the payment is too high but can get approved for a $100K interest only mortgage because the payment is lower, which was common over the past five years.

  10. lorax Says:
    April 4th, 2007 at 6:38 pm

    > In the short run, sure you’ll have some volatility. However,
    > over the long run, you’ll most likely do fine.

    This is a common misconception about the stock market. In truth, the risk is there at any time, from short to long. Example: you planned to retire in 2001 and had almost enough in your 401k. You’d been saving for 40 years for this moment. Then in a matter of months you’ve lost 20% (if you’re lucky). It takes years for the market to recover.

    That short run risk is ever-present. Even at the end of a long haul.

    And this leaves aside the problem of getting 10% (based on valuations a total stock market return will be lower) and leaves aside the US market survivorship bias.

    On the other hand, if you’re young enough to ride out a down market, you’re in the catbird seat… so long as it happens early.

    I think we’ll have to agree to disagree. I see the risk increasing since you’re now buying stocks on margin. Sure it might pay off, but then again, we might have a stock market crash and a property market crash.

    To quote Kaynes: The market can remain irrational longer than you can remain solvent.

  11. JLP Says:
    April 4th, 2007 at 8:15 pm

    lorax said:

    “This is a common misconception about the stock market. In truth, the risk is there at any time, from short to long. Example: you planned to retire in 2001 and had almost enough in your 401k. You’d been saving for 40 years for this moment. Then in a matter of months you’ve lost 20% (if you’re lucky). It takes years for the market to recover.”

    That’s why understanding HOW the market works is important. A recently-retired person is still a long-term investor. Sure, it may hurt to take a 20 – 30% haircut but it can be overcome.

  12. db Says:
    April 4th, 2007 at 10:52 pm

    I think I’m going to start stashing my cash under my mattress. That’s in my rental unit of course. I don’t even own the bed. (Who needs equity?)

    db

  13. zen Says:
    April 5th, 2007 at 12:51 pm

    Okay, I’m looking at buying a home soon – looking at this makes it seem like what I’m looking at spending (160-170k). Interest only would mean much less payments up front, and also allow me to invest the difference… I’ll have to weigh in on this before I commit.

  14. lorax Says:
    April 5th, 2007 at 7:04 pm

    > A recently-retired person is still a long-term investor. Sure, it
    > may hurt to take a 20 – 30% haircut but it can be overcome.

    This really depends on how much you take out, and especially if you can adjust your withdrawals based on the amounts left.

    Take a look at Bernstein’s analysis… . Relying on the returns of stocks can be a real problem if you get hit early in retirement.

    http://www.efficientfrontier.com/ef/998/hell.htm
    http://www.efficientfrontier.com/ef/101/hell101.htm
    http://www.efficientfrontier.com/ef/901/hell3.htm

  15. AllFinancialMatters » Blog Archive » JLP Responds - Interest-Only Mortgages Says:
    April 9th, 2007 at 12:19 pm

    […] I’m a little behind on reading the comments to some of the posts over the last few days. DB of Debt Blitzkrieg left the following comment on my Interest-Only Mortgage Update post: On the other hand it would be interesting to see where you’d be if you paid off that mortgage in 25, 20, 15, 10 and 5 years instead of either 30 year option, and then invested the full payment each month of the remaining 30 years. […]

  16. Mighty Bargain Hunter » Roundup for week of 1 April 2007 Says:
    April 11th, 2007 at 9:30 am

    […] All Financial Matters might tip his hat to interest-only mortgages under certain circumstances. […]

  17. Dnis Says:
    April 14th, 2007 at 10:08 pm

    I was recently told of a 40yr “fixed” interest only loan. What I don’t understand is how I could possibly only pay interest for 40yrs? Isn’t there a maximimun amount of interest that would be written on the settlement agreement, and wouldn’t that mean I’d actually start paying on the principle before 40yrs is up?

  18. AllFinancialMatters » Blog Archive » The Top 5 Reasons to Pay Off Your Mortgage? Says:
    May 14th, 2007 at 10:31 am

    […] Interest-Only Mortgage Update […]

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    February 4th, 2008 at 3:57 pm

    […] Interest-Only Mortgage Update […]

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