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
One other reason is if your income varies a lot from month to month. Someone who works in sales might have a fairly low base salary, but expect to get bonuses every month/quarter/whatever based on sales commission. So they would use an interest-only mortgage for the lower payments to fit their lower base salary. Then, they would use their bonuses to pay down the principal when they could.
It’s essentially like rent, but any increase in property value belongs to you. Of course, if the house goes down in value, you either have to be able to pay to sell it, or you’re stuck there. With a traditional mortgage, even if the home price stayed level, you’d accrue equity over time, here you don’t.
If the home price goes up a lot and you move within a couple years, you’ve come out ahead. If the home price only goes up a little, or you’re there for many years, it’s probably not that great. If the home price goes down and/or you can’t move for whatever reason, it’s bad. But, so long as you can service the mortgage, you won’t be homeless. If it’s variable rate, then you could eventually wind up with a *more* expensive mortgage than if you had gotten a traditional mortgage in the first place.
So, it’s a risk, but there are certain situations it could work out.
Selling a house is expensive. If you can’t quite afford the home you need right now, and your income is expected to go up, and the interest is less than a rent payment, you can buy the house now, make bigger payments later, live in it longer, and still come out ahead.
It’s a very narrow use case, but a lot of people only deal in “what payment can I make each month?” If they can have something and pay for it forever, that’s better to them than not having it.
I’ve done interest only loans because I needed them for business growth. Anything to keep the payment low until income picked up. I used to build houses. I knew it was going to sell, but I needed money to finish it. The lower the payment the better. Once the house sold, it all got paid off at one.
I’d rather have an interest only mortgage, than 26+% credit card debt. You do what you need to do.
Sometimes people make stupid decisions though. Not everybody understands interest.
Planet Money, possibly The Indicator just did a podcast on car payments. Somebody put $50,000 down on a new $80,000 Escalade, made $30,000 in payments, and owed $75,000. Make that make sense.
Interest only loans are typically used by house flippers, they’re advantageous for a couple reasons. First you only have to pay the interest, so if you can buy a $200,000 house and fix and flip it for $350,000 in 1 year, then with an interest only loan at 3%-5% you would only have to pay $6,000-$10,000 for that loan (with the house generally as collateral) and this interest doesn’t compound, so they know they only need to pay $500-$833 per month. This allows a house flipper to significantly minimize their risk. Furthermore, since they don’t own it for a full year, they often don’t have to pay property taxes on the property, (and potentially don’t have to pay much taxes on the loan). Additionally, being able to buy it in cash from a bank (and not using realtors) means they might not need to pay closing costs (which are usually a percentage of the sale).
The downside is that the principle needs to be fully paid off by that small timeframe (~1-5 years).
And is a LOT more expensive per year than a traditional mortgage, since paying down the principle doesn’t reduce the interest amount.
TLDR; house flippers can get a loan for a house very cheaply usually with the house as collateral. This lets them not have to pay a lot of things that would cut into their profit such as; principle payments, property taxes, or sometimes even closing fees, and would allow a house flipper to still make a profit even if they only increased the house value by ~10%-15%.
The big downside is that paying down the principle doesn’t reduce the interest payments, (if you paid it off next year or tomorrow you’d still owe $10,000+ principle).
One of the scenario’s is when you expect a bunch of free cash in some future. A few examples:
Eg you are selling your house but need more time to sell when you have already closed on your new one. A loan of x years gives you a full year of ease of mind; you only have to talk to the bank again when that period is almost over; but until then you can take your time to sell your old home. As soon as you have the cash of the sale, you pay back the loan.
The example of /u/jeo123 of property developers is similar; and if they have multiple properties, then they can pay off the loan by selling another property instead. They could prefer to sell a property in a neighbourhoud which is popular, and wait for the newly bought one to increase in popularity.
If you have assets which are tied to a deadline like stock(options) you cannot trade for X years or bonds which are under pari and you need to wait for them to reach maturity. Or if you expect to retire in 10 years and sell your company; then you can take out a loan of 15 years (to give you some margin) to already buy the place where you will retire.
As per the other comments, if the other assets increase in value, you gain extra; if they depreciate you lose out some.
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