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JLP Responds – Interest-Only Mortgages
By JLP | April 9, 2007
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.
My response:
Actually, I already detailed this in A Follow-up to the Dave Ramsey Mortgage Post – This is Interesting! It all boils down to allocation of funds. Even thought you may pay off a debt sooner, doing so requires you to use funds that could be used somewhere else. In other words, if you pay an extra $500 per month on your mortgage, you’ll pay it off sooner but you’ll be using $500 per month that could have been allocated elsewhere.
If the market returns 10% per year while you’re paying off your 6% mortgage early, you’re missing out on that 4% difference. Yes, there’s an “if.” We simply do not know what the market will return in the future. However, over the long-run, the stats are pretty convincing.
Related:
Mortgage Comparison Calculator XL
Topics: Calculators, Financial Math Basics, Mortgages | 7 Comments »
April 9th, 2007 at 1:39 pm
I’m in the early stages of buying a house (maybe — haven’t decided). If I buy one, I’m going interest only all the way. No need to tie up additional capital returning an after-tax 3.85% by paying down the principal. I have the funds to extricate myself from any downturn in the market and therefore do not see the need to pay it off. For some people a 4% guaranteed after tax return is attractive — not for me.
April 9th, 2007 at 1:44 pm
Kurt,
Just be sure you know EVERYTHING about your loan. These things aren’t for everyone.
April 9th, 2007 at 4:04 pm
JLP:
I’m going to try really hard to answer this once and then not get sucked into further discussion, mostly for my own sake since this is causing me unhappiness.
I didn’t recall your prior ‘Dave Ramsey’ point mostly because my head is always overfull of stuff anyway. I remember reading that when it was fresh and having a fundamental dissatisfaction with it that it was missing part of the point of early repayment.
We are just going to have to agree to disagree, and go with the true yet hackneyed “this is what puts the personal in personal finance”. By your math in the DR post paying it off early means that according to your arbitary (yet reasonable) hypotheticals paying that mortgage off earlier puts you $300,000 behind.
The issue is that no matter how much you rely on the past to draw inferences about the future, there is still no certainty over how the future will play out. It may be that your assumptions are spot on. And then again there may be other life issues along the way that interfere with the best-laid plans.
The reason this whole thread is causing me unhappiness is because I think figuring this out by the math is useful only to a point. Your math fails to consider non-quantifiable, non-tangible factors – layoffs, unexpected illness, a desire to simply shift gears among them. I think it’s really difficult to anticipate what is going to happen in your life long-term, and that thus the prudent choice is to act to minimize debt NOW regardless of if it’s OK debt or not. This is a value of mine, and it’s not going to be swayed with your number crunching. It’s not something that stems from my head, its rooted in my gut.
That doesn’t mean you have to be a slave to paying down your mortgage or pay some crazy amount and sacrifice all savings or enjoyment of life, but I think a household owes it to themselves to give themselves the sort of freedom that comes from not having a mortgage as early as it is feasible. The difference of $300,000 becomes less important since you had more time to invest more money. In that scenario, you could retire earlier, or you could downshift jobs – things you can’t do as easily if you are servicing a mortgage.
My opinion only holds for instances of a household trying to keep their primary residence over their head. Investment properties for “cash flow” purposes are frankly outside of my interest and outside of my thought processes on this and I intend to never have anything to do with investment properties. It’s beyond me — I’ll be lucky to even own a home someday.
DB
P.S. – I accidentally posted this first in “frugal vs. cheap”.
April 9th, 2007 at 4:38 pm
Nice breakdown of the various options. Moral of the story is each option is rather similar. However this works out if you have the financial fortitude to allocate each $1 you save and funnel it to an account yielding the expected rate of return. I would argue that the majority of recent home buyers were ushered into interet only loans simply because they could not make the ratios otherwise.
In addition, the interest rates on these loans are much higher than given on the sheet. Since this is assuming someone has prime credit while the bulk of folks jumping into these products are sub-prime. Another thing that is missing is the cost-effect of rates rising in the future. So having a fixed rate would be a lot better.
The best bet for the bulk of the population would be fixed rate mortgages. If you want to pay it down early you can without the pressure of having a 15 year nut each month. Or you can ratchet back and go to the minimum payment. I know you’ve discussed it before but simply paying your mortgage on a bi-monthly schedule will make your 30 year mortgage into a 23 year one.
Really great work and fascinating to see how great financial advice like this is rarely followed by the majority of the population. Maybe because it requires deferred gratifcation and self discpline, matters of psychology and will as opposed to finance.
April 9th, 2007 at 8:17 pm
I’m purchasing a house (hopefully) soon. I chose not to go the interest-only route for a few reasons – the market, while being able to guess on good rates, is not the most reliable thing, life gets in the way (much like DB said) and like the good Doctor said – that’s a great rate for Prime borrowers, but not necessarily for everyone.
The figures and situations are great in paper, but the larger market (the teeming masses) I don’t think it falls to be applicable (meaning – just because I wouldn’t do it or endorse it doesn’t mean there isn’t somebody pulling it off and making some bucks on it!)
April 9th, 2007 at 9:12 pm
OK, I have to chime in one more time — just to try and show that I’m not totally unreasonable on this issue.
All I can really speak to is how *I* would do this. What I plan to do when I buy my house (assuming it’s in the US) is to take out a 30-year fixed mortgage. NOT a 15-year fixed. It’s also a rule of mine that when I do this I have to be able to make a 20% downpayment to avoid PMI. So my budget for the house will be whatever I can swing 20% of AND be left with an affordable 30-year fixed mortgage.
Then, AFTER I have my full retirement savings taken out of my monthly pay plus set aside something extra and meet living expenses, whatever I have left I’ll snowball onto the debt. If I can’t snowball then I can’t. But I’d try to make sure I was in a position to pay off the mortgage early and still save. My goal would be to pay off the 30 year mortgage in 15 years or less but I wouldn’t sacrifice saving to do it.
Of course, before I can do this I have to get my student loan albatross off my neck (and yes, I have built in saving while I’m paying down the student loan.
DB
April 9th, 2007 at 11:04 pm
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