Are Interest-Only Home Loans A Good Idea? (Mostly No)

Kim asks,

I was wondering what you think of interest only home loans. i trust that you know your shit so a simple “good idea” or “bad idea” reply would be enough for me to decide.

Have you been reading the papers? Most of the time, Kim, they’re a bad idea. Interest-only mortgages are a driving force behind the collapsing sub-prime lending market.

These loans work by making you pay only the interest on a loan for a fixed term. After that, you refinance, pay off the balance in full, or start paying down the principal, at which point the payments go stratospheric.

In recent years, brokers aggressively marketed interest-only home loans to downmarket customers. By hook or by crook, they convinced thousands of borrowers to only focus on the affordability of the initial payments.

The financial tool was developed mainly for executive types who earn a moderate income and then receive big bonuses. If you’re not one of those, an interest-only home loan probably isn’t for you. — BEN POPKEN

FURTHER READING: Who should get an interest-only mortgage? [Bank Rate]
(Photo: amyadoyzie)

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  1. kerry says:

    A friend of mine got one of these loans just so she could get a condo, and now overpays monthly with the excess going to the principal, so that she’ll be able to refinance with a better lender in a couple years. She knows it’s not the greatest loan around, but it got her into a condo and she can work a budget like nobody’s business so it’s not a terrible choice for her. Somebody less financially savvy would drown in that loan pretty fast.

  2. m. mangosteen says:

    We got an interest only loan on our house in 2005, but also put down 40% in cash. Like the poster above, we pay down a little of the principal each month. The arm expires in 4 yrs so we have some time to figure out a new plan, but it’s working for us so far.

  3. The_Truth says:

    Why put money into the principal?

    Why not take it and drop it into some sort of savings vehicle?

    The interest you earn on the sum can then be applied at the refi point giving you a better down payment. Plus if things go badly and you have to sell your house at the same cost as you brought it or less, you wont have lost any value.

    As an added benifit should things truly go to crap, youll have an additional sum to tap into, rather than be sat there wondering how to get the principal back.

    Just my thoughts…

  4. markymags says:

    Ben, please correct this statement:

    “Have you been reading the papers? Most of the time, Kim, they’re a bad idea. Interest-only, or “option ARM,” mortgages are a driving force behind the collapsing sub-prime lending market.”

    Not all Interest only loans are Option ARM loans. Option ARM loans do contain an Interest only option but Interest only loans are not the same as Option ARM loans. Let me put it this way:

    - An Option ARM loan gives you multiple payment options, among them a negative amortization payment, interest only payment, and fixed payment (this payment can be based on a 30, 40, or 50 year payment schedule)

    - An Interest only loan actually contains two options… you can pay only the Interest or, as the first couple posters stated, pay more and have the excess go towards the principal

    I actually have an interest only loan (I purchased a home in 2006) and put a little bit extra every month so my principal balance gets paid down a bit. My interest rate on my interest-only loan is fixed for 30 years and while I will have a larger balance at the end of 30 years (if I do not refinance within that period of time) I always have the option to pay only the interest and keep my credit score in the 700s instead of gathering lates on my payment because I cannot afford the higher payments of a principal+interest loan.

  5. Craig says:

    Assuming you do get a loan that converts, what if you’re buying as an investment in a market where values are still climbing?

  6. Treved says:

    I also disagree with this post. I have an interest only with a pretty low rate (5.5%) for 10 years. I also put about 35% down to start.

    I pay off the interest each month, sometimes with a bit of principal too. But as long as my investments are making more than 5.5%, why pay off principal?

    Incidentally, it probably helps that I live in LA, so my house probably will never significantly decline in value. I guess if it did I’d be screwed, but chances are slim.

  7. frowelishnu says:

    @Craig: Buy Hawaiian. The market here is insulated from the rest of the nation and still rising, monthly.
    If you sell within the intro period 3-5 years depending on the loan you should do well.
    Of course, realize that I am an anonymous voice on the internet – and not a registered realtor or investement counselor.

  8. ironchef says:

    i thought interest only loans are basically for house flippers…people who buy property and resell it after renovation.

  9. kerry says:

    @ironchef: I think a lot of people use them for that, but also people without the greatest credit or greatest consistent cash flow can get an interest-only loan but be denied for a traditional loan, so it’s a good option for those like markymags who can often pay down principle but want the safety net of a lower required monthly payment.

  10. nequam says:

    @m. mangosteen: @Treved: I don’t understand why you would take an interest-only loan if you had 35-40% to put down. It seems to me like you bought a nice chunk of equity, but then chose to let your principal sit and ultimately cost you a lot of extra money in interest. Am I missing something, or wouldn’t it have been better to pay 20% down and put the rest into a decent savings account to draw down for monthly payments. Even if the interest on the mortgage exceeded the interest earned on the savings, you would probably still end up paying less in the long run. Are you in it for the short term? Maybe this is just over my head (what else is new?)

  11. TheName says:

    @Treved: Not so much. The math simply does not work out and I’d like to hear the line they fed you to convince you it does.

    Interest only loans are all but predatory, convincing borrowers to “stop throwing away [their] rent” by paying substantially more per month (rents are far below mortgage payments in the current market) for almost exactly no benefit. Think of it as renting “their” home with a guaranteed rent increase 10 years in the future. Until those 10 years are up the borrower owns no more of their home than they did their rental.

    Despite what other commenters have suggested, I can think of not a single instance in which an interest only loan makes sense.

  12. rongenre says:

    I don’t get that one either.. you can get a 30-year fixed mortgage with an interest-only option (which a lot of people don’t seem to grok), but you pay a bit more in interest for that flexibility.

    I can see doing that if (a) I don’t have much cash for a down payment and (b) my income’s lumpy but probably there — say I get paid in big bonuses, or work in sales. What they tell you, when you’re being responsible is that the income’s probably there.. you’re not counting on a promotion or getting suddenly richer.

    But if you have 35-40%, you should have enough to pad your income between bonuses, and not pay the high interest rate.

  13. rich815 says:

    “by making you pay only the interest”

    No they do not, you can pay as much as you want, as least at Wells Fargo for their interest-only loans.

    “you can get a 30-year fixed mortgage with an interest-only option (which a lot of people don’t seem to grok), but you pay a bit more in interest for that flexibility”

    Again, not true, at least at Wells Fargo where for the jumbo loans (over $417k) their is no premium on the rate for a 10 years or 15 years of interest only on a 30 year fixed loan.

    Overall interest-only loans can make sense in two cases:

    1. you put down less than 20% and have 2 loans, a first at 80% of your purchase price, a 2nd to cover either 5, 10 or 15% of the price, as line of credit second mortgage. Then an interest-only first makes sense as you should not pay down the principal on the lower interest rate first when you have a balance on the higher interest rate second.

    2. You have other debt than your mortgage which has a higher interest rate, like credit cards, auto loans or education loans. Clearly you should put money towards paying off those higher interest rate balances before paying down the principal on a lower interest rate mortgage. Also remember when comparing rates than in general the interest on your mortgages (first and second) is tax deductible so for example 6% is more like 4% or so after tax benefit.

  14. LAGirl says:

    @rich815: i completely agree with you.

    mortgage interest is a 100% tax write-off, while the principal is not. depending on your tax bracket, and deductions, you could see a big difference on your tax return. although, if you file a Schedule A and have a lot of itemized deductions, then the interest might not make much of a difference (FYI: don’t forget that your property tax is also a write-off).

    also, certain areas are still seeing modest/healthy gains. so, even without paying down the principal, you could see an increase in your equity.

  15. Greeper says:

    Like everything, they can be good or bad. I have I/O loans on 2 properties I rent out. THe rent covers the interest; I’m not paying it down but I’m not losing anything. I had an I/O on my principal residenc until the higher rate kicked in after 3 years. It was a great deal for 3 years (4.375%) and then I just refinanced it into a 30 year fixed. I personally think they are a good idea IF, when the low I/O rate period ends, you won’t be stuck with payments you can’t afford AND you won’t be able to refinance.

  16. shoegazer says:

    I know it seems a world away from the US property market, but UK property investors use interest-only fixed rate mortgages to secure a property and then sell it on for capital gains (which are tax free on your main residence). I know it’s no comfort in a falling market, but it is definitely useful where you see yourself selling on before or just after the fixed rate expires, typically because the rate discount is substantial.

  17. Brad900 says:

    I also am an I/O Mortgage holder (also with Wells Fargo)- and I put a little more than 20% down. This is my first property- I am not in it for the long haul. My thinking was that I will get the maximum tax benefit, and that there is almost no possible way that I will be here in 10 years when the principal is scheduled to kick in. I had my choice of conventional or I/O and I chose to go this way because in the “5 years or less plan” it seemed to make more sense to me. If I do decide to stay after 2-3 years them I’ll just refinance an be right back in the mix.

  18. TheName says:

    @Greeper: So what’s the point of the rentals? There’s no extra income earned. No equity built. And if prices don’t rise fast enough you’re SOL when it’s time to dump them to avoid having to jack up the rent you need.

    As for your “great deal” on your primary residence, how is it so? You essentially rented the place from the bank for those 3 years and then repurchased it from them after that time. Where’s the deal here?

  19. not_seth_brundle says:

    @TheName: “(rents are far below mortgage payments in the current market)”

    What geographic area are you defining as “the current market”? Let me guess, San Francisco? L.A.? Here in the fly-over zone (Chicago), there is not such a big disparity.

  20. Brilluminati says:

    Hold the horses…

    I think this post is about a Pay Option Arm mortgage which gives the borrower an option to pay the minimum interest and principal payment at a rate between 1-4%(most goes to interest, so that why it would appear to be interest only).

    These loans also give the option to pay the full 30 mortgage payment or the true interest only payment (based on the fully amortized rate).

    Despite the error in the title, the pay option arm loans are pretty much BAD for any borrower unless you take the money that you defer interest and invest or put it into another vehicle improve your assets.

  21. mxmora says:

    Most of you must not live in the SF Bay Area. :-) Real estate here has been the best investment earning way more than investing money in the stock market or any bank. Option ARMS and Interest only loans are great ways to get into better neighborhoods with the most appreciation potential. Even with the softening market, real estate here is still a pretty safe bet. (think of it as a buying opportunity) For folks with 5 year or 10 year plans who don’t plan on staying in their house for 30 years these loans are a good option. The appreciation far out earns any principal paid in 5 years. 12 years ago with 20k down payment I was in a 200k house. Six years later with 200k in equity I was in a 500k house. 6 years after that with 400k of equity I’m in a 1mil dollar house. 5 years from now, who knows, either in in a 2 million dollar house or the poor house. :-) With any investment there is risk, and when these loans come due, you are hoping that the market is in a good spot or you could get burned but that is the same with any high yield investment. Though this risk could cost you the roof over your head.

  22. mr_pants says:

    One thing to thing about with an I/O is that if you pay down the principle (i.e; pay over the minimum interest payment) you actually reduce you monthly minimum payment. Whereas on a 30 year fixed when you overpay you shorten the loan life, but the monthly minimum payment never changes.

    We have an I/O that we pay both P+I just like a 30 year amortized loan. We got a lower rate than a 30 year loan and we have the option of just paying the interest should we have an emergency.

  23. TheName says:

    @not_seth_brundle: Good point. Or not.

    I would suggest the “current market” encompasses the whole of US real estate. There are always outliers but if the data fit …

    It’s not restricted to major, hot urban markets unless you consider Billings, Montana such a market.

    Play a bit with the Nextag Chicago mortgage data and tell me where there is no disparity. In case you’re wondering, the median rent of approx. $615/month (with $20,000 down) would pay for about a $100,000 home. Note that $100,000

  24. Nemesis_Enforcer says:

    @not_seth_brundle: Ha I would like to know where Rent is far below mortgages out here in LA. The cheapest I can find a 2 bedroom apt. that would not require me to wear a bulletproof vest to and from my car in the garage is over $1500 a month..F that !

  25. not_seth_brundle says:

    @TheName:

    I don’t know if it’s fair to compare median rents to median home prices. There are always going to be more studios for rent than for sale, and more mansions for sale than for rent. More meaningful I think would be comparing a rental unit to a similar purchased unit.

    My larger point was that there IS no uniform “housing market” across the US. It varies from state to state, metro area to metro area, city to city, neighborhood to neighborhood, block to block. I was speaking from my own personal experience as I just shopped for a condo in a fairly stable area of the city. A 1/1 apartment in this neighborhood rents for $1200+. A comparable 1/1 condo on the same block sells for $210,000.

  26. not_seth_brundle says:

    @Nemesis_Enforcer: What is the cheapest you could find a 2 bedroom condo in the same neighborhood?

  27. TheName says:

    @not_seth_brundle: I think “uniformity” is a stretch but you’d be hard pressed not to see trends that can be adjusted for. A statement like “prices are rising faster than rents” doesn’t really beg the response “well, not on this block”.

    Comparing median to median takes the population and says “50% of the people who rent pay less than this and 50% of the people who buy pay less than this”. How that’s not a valid comparison is slightly beyond me I guess.

    In any case, I–and many others–see a trend in these data and it points to a disparity in rents and mortgages which is only heightened by interest only loans.

  28. not_seth_brundle says:

    Trends are one thing. Saying “I can think of not a single instance in which an interest only loan makes sense” based on trends in the “market” as a whole is another. (I didn’t do an I/O by the way.)

  29. mathew says:

    You guys might want to read about the big interest-only mortgage scandal that hit the UK in the 1990s. A lot of people got really badly screwed.

  30. TheName says:

    @not_seth_brundle: The trends suggest that the outliers will follow similar trends and therefore they do not justify an interest only option. There are very few scenarios in which it makes sense and they likely have little relevance to most people. In toto, they will hurt more people than they help.

  31. adamondi says:

    I decided to go with an interest only mortgage because of the following conditions:

    1) The housing market in the Seattle area is still healthy. My equity is growing without having to pay off any of the principal.

    2) I plan on selling the house within a year. I am not flipping it, since it is my primary residence and I am not making significant improvements. I simply am planning on moving soon.

    3) You pay off almost no principal in the first several years of any mortgage anyway. If it is a short-term investment, then paying off principal usually does not have a good enough return on that investment to make it worth while.

    If any one of those three conditions was different, I would not have chosen an interest-only loan. It just so happened that in my case, it was a perfect fit. I still think that negative amortization loans are the scourge of the housing market, though.

  32. mac-phisto says:

    imo, i think an option-ARM is actually better than a traditional fixed-30 in certain circumstances & used correctly. it’s def. smarter than strapping yourself with a traditional, using credit cards to fill an income gap & then tapping your equity with a refi every year or two.

    if you’re purchasing a property with the intent of making major renovations, an option-ARM will probably work more toward your advantage. the extra cash you have can be used toward increasing your home’s value instead of plopping everything onto a card. plus, these renovations can be used to increase your home’s equity when it comes time to refi.

    of course, the trap is that you pay i/o, still rack up cards & dispose more of your income & then wind up screwed when you try to refi or your payment goes up. it only requires a little discipline (& a rudimentary budget) to keep this from happening.

    eventually, if you plan on keeping the property, you want to end up in a traditional, but don’t overextend yourself to get there.