What if I told you that hands down, an Interest-Only mortgage is a much more prudent use of your real estate funds compared to a conventional loan over a 10-year time period, all other things being equal? This comparison takes into account the present value of money, the equity that you're not building by going the interest only route and in the event the housing market crashes, the difference in risk is negligible, contrary to media accounts. The Net Present Value (NPV) of an Interest Only mortgage is an improvement of 5% (more on that later) compared to a conventional 30 year mortgage.
With the sub-prime market undergoing a meltdown and the real-estate market still declining or languishing, there are legitimate concerns related to all facets of home buying. Of the common mortgage options (conventional 30 or 15 year, adjustable rate mortgage [ARM], Interest Only ARM, and Option ARM/Negative Amortization), the conventional is the most conservative and oft cited as the only way to go for people with their heads screwed on right. The news accounts of "risky" interest only mortgages and the certain disaster they bring would make anyone think twice. In most cases, these fears are overblown and misunderstood. I've seen some accounts where the media is actually mistaking a an Interest Only ARM for a negative amortization loan (which combined with nothing down is extremely risky and I would never recommend it under any circumstances). In this post, I will prove to you that aside from the added benefit of getting more house for your money (don't compare this to leasing a car...different post), all things being equal, an Interest Only ARM can actually be a better use of your funds with roughly equal risk.
First, some brief points on different mortgage types:
Conventional - Typically a 30 or 15 year, the payments start off as primarily interest with some principle and gradually transition over to increasing principal payments after several years. In this respect, early on in the mortgage, a conventional is not much different than an interest only. On a hypothetical $100,000 loan, during the first year, of the total $600 monthly payment, only $100 is going toward your principal and the other $500 toward interest.
ARM - You can have a conventional loan that starts with the first several years with a lower set interest rate, which can increase later, based on a widely utilized rate index. The reason buyers opt for the ARM is that the initial lock-in rate is normally lower than the going 30-year rate (excluding rather bizarre economic conditions). Typical terms are 1,3,5 and 7 years. After that, a standard contract allows for the rate to increase each of 2 years for up to 2%, for a maximum of 4% over your initial rate, if rates were to increase that much. Although the rate is initially locked, you ARE still paying both interest and principal.
Interest Only ARM - Just as it sounds, during the initial lock-in term of say, 1,3,5,7 or 10 years, you pay only interest with no principal AND the rate is locked. After that term, all bets are off; the rate can increase AND once the lock-in period is over, the payments increase substantially because the principal is now to be paid over the remaining term (i.e. all 30 years of principle paid over 20 years, plus the interest). When you sell your home, or refinance, you have no equity built up from principal paid to the bank since you were only paying interest. The naysayers cite this as a risk in that if the real estate market tanks and your house declines by 10%, if you try and sell it, you won't have built up any equity and you can actually lose money on the house. To cite this is an unacceptable risk over a conventional is just silly. Over a period of a few years, the exact same would be true of a conventional since so little is paid in principal up front anyway. What is often confused in the media is the amount you put down or if it's a Negative Amortization loan that can result in this loss upon sale.
Negative Amortization/Option ARM - Although the lenders will rarely call it a negative amortization, that's what it is. When you see an ad for a 1% loan rate, exercise your "option" to run. Although there are various payback options, what typically occurs is someone buys much more house than they can afford by starting with the low teaser rate. During this time period, if their house doesn't appreciate rapidly enough (and these days are over, so don't count on 10% annual appreciation again during our lifetime), they actually start to accrue a negative amortization. You can buy a house for for $300,000 and when you sell it for $300,000, although you'd break even on a conventional or ARM (excluding all closing/transfer costs), you could actually OWE tens of thousands after a couple years. This type is like rolling the dice and I've never come across a scenario where this is a prudent decision (unless perhaps you had a crystal ball in the late 90s and foresaw the unprecedented irrational exuberance in the real estate market and then got out in 2005).
Full Disclosure: I am a daredevil with an Interest Only ARM. I just love living on the edge (sarcasm). I decided I had to write on this after seeing enough press accounts of the delinquencies and bankruptcies related to adjustable rate mortgages. I also like to maximize my cash flow (proof via financial model below). Here's why this made sense for me:
I'm not sure if I'm going to stay in my current house for life. Obviously, if you want to own your house someday, you eventually have to pay principal and can't go on engaging in interest only mortgages forever. In my case, I'm young enough that if I decided to stay, I could simply refinance into a 15-year conventional; since I went with a 10-year Interest Only ARM, I have plenty of time to decide and will certainly either sell refinance during that time.
Since mortgage interest is tax deductible, there is a significant tax advantage to doing an Interest Only. This is factored into my model.
The principal that you pay to the bank as part of a conventional mortgage is free money you're giving the bank to invest and accrue earnings for the years until you either own the house outright or sell it. If you do an Interest Only and invest the same amount of principal you'd be paying the bank, there are obvious benefits. Why would you invest money at zero percent when inflation is 2-3%, savings accounts exceed 5% and the long run average of major market indices are 8-10%? With these principles in mind, I developed a model to compare the Interest Only ARM to a 30 year conventional over a 10-year period with the following assumptions:
Any loan amount will return the same result; I arbitrarily chose $300,000.
I chose a standard 6% interest rate for the loan. I'm reporting the results using a discount rate (what the value of money is to you; i.e. what you could earn investing it elsewhere) of 9% (conservative long-term market average), invested just once per year for simplicity and real life practicality.
All equity accrued through principal payments for the conventional are recouped upon sale or refi at year 10. However, this amount is discounted back to present value since the NPV calculation requires that all values be just that, present value. The ARM accrues no equity obviously, only earnings on money invested.
I accounted for the difference in tax benefits for the Interest Only by using a 25% tax bracket, which for married couples in 2006 was $61,300-$123,700 (Link to full tax brackets below), a common bracket in the U.S.
Any future appreciation in the house would affect each model equally, so there was no need to include in the model.
All closing costs, transfer taxes, etc. are assumed to be equal for each loan. Here are the results. If you'd like to request a copy of the excel version to review, use for yourself or refine, feel free to contact me at the email address listed above. Regarding NPV, that's for another post, but trust me, it's the most comprehensive best way to calculate the current value of an investment - beats payback period, % return, etc. Utilized excel financial functions to ensure accuracy.
For the model, the results are as follows:
Total NPV is $90,741 for conventional vs. $86,638 for Int Only ARM. This means a conventional costs you over $4,100 more over 10 years (including the equity you built!). This is a factor of 5% more expensive to do a conventional. Under either scenario where you either get a lower monthly payment and more house for your money, or pay the same monthly payment for the ARM as you would have for conventional, but invest the money at 9%.
FYI - As your discount rate approaches that of your loan rate (say you're earning 6% in a money market and paying a 6% loan rate), the NPV becomes equivalent. However, you still get more house for your money. Don't give it away for free unless you are 100% sure you're retiring in that house.
http://ezinearticles.com/?Is-An-Interest-Only-Mortgage-Really-That-Risky?-In-Short,-No&id=588712
