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
It may be cheaper than renting the equivalent and you don’t plan to be there very long. Also if you think the value might go up significantly over a few years you could make money off of it. This is especially true if you are flipping the house.
They’re definitely a niche product… but here are a few scenarios.
– You’re a flipper who will be buying the home to remodel and sell, and want to keep carrying costs to a minimum. You plan to own for 6 months or a year and all your gains will be due to the work you put into the house, not paying down the mortgage.
– You’re buying a starter home/condo and think prices will keep going up, but that you don’t plan to stick around very long. Since most of the early year mortgage payments are going to interest anyhow, you go interest only, invest the difference and just hope to profit from value appreciation when you sell in a couple years.
This can make sense if you’re buying a house primarily as an investment, and you don’t plan to own it very long. You are betting that housing prices will rise rapidly, and you may be planning on being able to add lots of value to the home via affordable renovations (house flipping).
For example, if you expect the price of the home to rise by 10-20% over a year or two, and your interest rate is only 3% (assuming you have a time machine), the savings on payments will make up for the fact that you aren’t paying down the principal (assuming your prediction pans out).
The lower payments could also enable you to speculate on multiple homes at the same time. This increases your exposure to risk, but also multiplies your potential profit.
It works very well for investment properties you want the rent to pay you an income not pay off the mortgage so interest only works. Like any business you want your overheads as low as possible.
From an economic perspective you should always invest as much as possible to make your money grow. But you do want to live in a house so you take out a mortgage. But if the interest is lower than what you expect to earn from your money investing, you would rather spend as much money as possible investing and as little as possible paying back.
In recent years it was possible to get mortgages with 0.5% interest locked for 30 years. In that case it makes perfect sense to focus on investing your money, rather than “tying them up in bricks”. When the 30 years are up, you pay out the mortgage with the money you earned investing and keep the rest.
When interest rates are good, interest only is a much better choice. The S&P500 has averaged ~10% returns since 1928…..when interest rates were 3-4%, interest-only was a no-brainer. Nowadays it’s less clear (since you pay taxes on your market gains and in some cases can deduct part of your mortgage interest, etc).
To add to some of the points already made, IO loans are a popular option with investors as well.
Say you are looking to buy an investment property and rent it out. The purchase price is $100k and you secure it with an IO loan. You can set rent for your tenants to cover the IO payment or even more if you want. 5 years down the line the value of the home is up 50% and you sell for $150k. You just made $50k while someone else made all the payments.
Oversimplification as there are more costs to ownership, down payments, and all that fun stuff but that’s a basic breakdown of why you might get an IO loan on an investment property.
One reason is if you are expecting a huge change in your salary in the (relatively) near future – such as a doctor doing his residency. He might be making average money for a few years but can very realistically expect his salary to triple or quadruple after that point.
To add to others, these were more popular when rates were lower and it allowed people to get into homes they otherwise would not have been able to afford with a conventional mortgage from both a down payment and monthly payment perspective. Many interest only loans didn’t require 20% down.
Well, that is like paying rent when your landlord is the bank (in the US with their weird give-back-keys-rule even more so) and speculating on the housing prices moving in your favour.
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