From what I understand about mortgages, which isn’t a lot at all, I just don’t see any scenario where an interest only mortgage is a good idea.
You pay it off for let’s say 20 years and you still have the full balance remaining. What am I missing?
In: Economics
If you believe market growth will outpace what it costs you in interest, it can be more efficient to use the money you would have paid towards principal and invest that in the stock market.
After 30 years you’d still have the full principal left on the mortgage, but that’s a long enough timespan that the market should average decent returns and you should be able to sell your investments you made with the difference and pay the entire mortgage off if you wanted to.
Because it is cheaper than renting and you only plan on being in it for a few years before refinancing or moving and thus will save money based on loan origination costs.
An interest only mortgage have lower monthly payments, as you only pay the interest and no downpayment. In those 20 years you would have saved as much as the entire mortgage in cheaper monthly payments. You can invest these savings and on average end up with more money then if you made downpayments on your mortgage. The issue is that you are taking a bit of a risk. If the stock market drops at the wrong time you may lose your home.
Interest-only mortgages are for when your plan is to not live in a house for very long, and you also expect the house will greatly increase in value during that short time. (I think these were especially popular in the early 2000s.) I had a colleague who bought a townhouse for $200,000. He planned to live there for only a few years and then sell it for $300,000. His profit would be $100,000 minus what he paid in interest on the mortgage. His opinion was that an interest-only mortgage was a no-brainer.
Of course, the risk is that if you end up living in the house for a long time, or, if the house doesn’t increase in value, then an interest-only mortgage is a terrible idea. I would never take that risk, personally, and I don’t know how it ended up working out for my colleague.
Interest only mortgages were intended for developers and people doing housing renovations to flip the house. Basically you’re trying to minimize how much cash you tie up in the property because you’re using that cash to improve the property. In theory, you sell it before this becomes an issue.
There’s nothing binding them to just that use case, and so people started making stupid choices. But that was their original purpose.
Some people may find well thought out situations where they make sense(e.g. if rates are low, lock in the rate now even if you can’t afford to cover the principal as well) but those are very specific situations and should only be done by people who actually know what they’re doing, not by people who just read a blog about it on the internet.
I think of it like paying to lock in the price. Say you find a property for $500k that you want to buy, but you cannot pay for it yet. For a relatively low monthly fee, you can lock that price at $500k and use the property as your own. As long as you keep paying that fee, the price stays $500k should you chose to pay for it later. In 5 years, every other place nearby costs $750k, but you can still buy it at the price you locked-in ($500k) if you want.
If the rate’s locked in then you have WAY more stability on housing costs during those years than you would while renting.
Assuming the interest is competitive with or beats rent, which it generally will be with ever rising rents, then you would use that time to build up your down-payment to refinance into a traditional mortgage. Or sell when you need to relocate.
Also provides a way to live somewhere just for a few years when the rent market is tight or exorbitant.
Just to add to the other answers it’s worth noting that if you have *any* investment vehicle available where the return will be greater than the rate of the mortgage you would be better off repaying the principal of the mortgage at the end of the term.
So if your mortgage rate is ~2-3% and a simple index fund averages 8% you’ll have more money after 25 years if you take out an interest only mortgage and put a bit of money into the index fund instead. At the end of the term you take enough out of the index fund to repay your mortgage principal and you’ll have some money left over even if you paid the equivalent amount in total to a repayment mortgage.
The issue of course is risk so this isn’t usually a good idea for residential mortgages. Not sure how it is in other countries but in the UK we have a bit of a looming crisis from self-certified interest only mortgages where the terms are coming up to expiry with no repayment vehicles, or repayment vehicles that failed horribly.
People are suddenly finding themselves hitting retirement with a lender asking for an appreciable fraction of their property value, especially in areas where said values haven’t increased as much.
Big thing you seem to be missing (at least in terms of how you asked your question) is that after 20 years, you’ve had a place to live for 20 years, which is a valuable asset in itself.
You are never obligated to make *only* the minimum payment. This is the key thing that you are missing. I think top level comments get removed if they dont have more text than a few sentences. So hear is some additional text to escape our AI overlords.
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