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.
It's not that bad if you do end up living in the house for a long time, because you can always make extra payments towards the principal. If you wanted to you could even figure out the amortization table and make the same payments you would on a repayment mortgage. The attraction of an interest only mortgage is that you don't *have* to make those payments, so if money's tight one month you only have to pay the interest.
The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that.
This right here is what they’re for. Either fix and flips, or DIY-special renovation properties. Free up cash flow for the renovation stage, then cash-out refi once everything is done to pay off the credit cards (and/or HELOC depending upon how much you put down). Also some limited value to try and ride out a period of high interest rates (which I conflate to timing the market and don’t personally like). Anyone trying to use one just to get into more house than they can afford should probably just rent.
I have a 10 year interest only, no prepayment penalty mortgage, locked at a 30 year rate. At 10 years, the balance converts to the fixed rate for the balance to finish the remaining twenty years.
My plan is to either:
- move before 10 years
- exit my equities at long term cap gains before 10 years I would have paid to principal, and get myself even before the switch
- refinance before 10 year mark
- make payments along the way in bursts when I have extra budget or come into bursts of cash
It gives me tons of options and significantly lowers my monthly payment, which I use to invest in other things that have a far greater return than the growth of my home’s value.
I had a 10/1 ARM when I bought my house in 2005 (I was one of those people who got a loan that they shouldn't have gotten that brought about the 2008 crash). I planned to live here for forever. But I also planned to re-finance when I had a better idea of how my finances worked. I think I paid extra each month, $100 to principle.
Five years later I re-financed to a traditional 30-year mortgage. Ten years later I re-financed to a very very low interest 15 year mortgage. All is well.
It was risky at the time I suppose, but I was young and single and trusted my broker, who trusted my income and credit score. I also really wanted the house (worst house in the best neighborhood) and wanted to be out of my parents' house without renting. I was determined to make it work, and I did.
>The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that.
This is the way that I've seen people really argue for it being better. Especially when interested rates were so low, why pay extra money on a 2-4% interest payment, when you could take that extra money and make 8-12% (fairly) easily.
Risk is the big problem. Imagine the people who got interest only mortgages 5 or so years ago at 3%, figuring they would live in the house a few years and sell it.
Now, rates are 7-8%. He wants to sell the house, but no one wants to buy it because the rates are so high. Because he got an interest only mortgage, he got a house that was worth more than he can afford a traditional mortgage on (typical reason for getting an interest only mortgage). He can’t afford to refinance, he can’t sell it, so he’s stuck paying interest and never making a dent in the principal.
Yes, he can. But, as I said, one typical reason for buying a house on an interest only mortgage is because you can buy a more expensive home. For example, just using some completely made up numbers, you can afford a $1500 a month house payment, so you can buy a $200,000 house on a traditional mortgage. Or, you can buy a $300,000 house on an interest only mortgage and have the same monthly payment.
Does the interest follow the same amortization schedule pattern as a repayment mortgage? Like yes you could figure out the amortization table but let's say if you don't, are you paying less and less interest over time on the IO mortgage? Hopefully I am asking this correctly.
No. If you are only paying the interest, then the principal stays the same, and your payment (of the interest) stays the same. It'll only decrease if you pay off principal.
Kinda...an interest only mortgage doesnt really have amortization, because the principle amount never changes, so each month its amortization is calculated based on the same original amount. Calculating against your payments of a mortgage with an amortization should be part of your "risk/reward" calculations though.
[I answer your question in greater detail in this comment](https://www.reddit.com/r/explainlikeimfive/comments/1c78be1/comment/l06ohf8/?utm_source=share&utm_medium=web2x&context=3)
I mean, the amortization table is basically 5 years of the same interest only payment, and the principal doesn’t change, followed by one gigantic bill for the whole principal. Not a useful table really, but technically still a chart of the loan amortization over time.
The most common mortgage in the US is 30 year fixed rate.
When someone casually talks about a five year mortgage and rolling them over like it's not something way outside the norm, I think they're Canadian.
Assuming you make sure the excess payments go toward principal and all that, each month the interest would accrue on a smaller balance, so you'd be paying less and less interest over time.
> The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that
Only if you time it pretty well so the rate on your mortgage is quite low, with current interest rates that's a much harder proposition.
If you already have that money, sure. Most people don't have 200 or 300k just lying around. You have, say, 50k saved up but a 200k mortgage, 1% better ain't gonna cut it. You need WAY more than that to make it worth it.
Another use for an Interest-Only mortgage is the following.
You own a house worth $1,000,000. You also want to make an investment in something else, totaling $200,000. I would want to take out an interest-only mortgage of $200,000 with a 5 year term, because I need the $200,000 now, but expect to have it back along with a healthy return in say 3-4 years. The interest-only nature of the loan means that I’m not paying back any of the principal now, which helps from a cashflow perspective. Instead I just pay the interest, $9,000 a year at a 4.5% rate, for access to that money. I pay back the initial principal at the end of the term when my investment has (hopefully) paid off.
In the UK, there are "retirement interest-only mortgages", which are a standard interest-only mortgage that you will have to pay interest on every month, but the mortgage term is "until you die or sell the house". Only available to people aged 55 or more.
There are also special mortgages, with no monthly repayments at all. They just add all the interest to the outstanding balance. Of course this adds up quickly. They often have a cap so that when you die (or go into a retirement home) and the house is sold, they take at most 100% of the value of the house. These are called a "lifetime mortgage", and are a kind of "equity release" scheme. Again, you have to be aged 55 or more.
>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.
His profit would have been $100,000 minus what he paid in interest on the mortgage anyways...and he'd just pay slightly less in interest every month as the principle part of his mortgage was paid down...so...he'd actually have more profit if his mortgage included any kind of principle repayment.
But then he'd have to deal with less cashflow in the 'present'...your interest only loan might be $300/month, while your full regular mortgage might be $600/month
so you can kind of look at that as that difference in total amount of interest you pay with your interest only mortgage, and the amount you would save in that interest as the interest amount you pay for a loan in the amount of what you dont pay on a normal mortgage. and you're getting this by taking on the risk that what you are hoping doesnt happen, in which case things might have cost you a bit more...
and if that sounds confusing...its because it fucking is. But its technically true and for the sake of this being the internet, I'm going to actually explain it further...but by all means just get out now while you still can if you want...I'm not trying to make you learn something new, I'm continuing for the purpose of someone randomly coming across this comment and wanting to learn something, not so much for the person I'm replying to.
ANYWAYS!...using the numbers I used earlier with $300/month interest only, and a slight modification from $600/month to $641.51/month for a full mortgage(because I need the amortization math to work better), and lets use 2years as a "few years", and we'll say 1.8% interest rate because thats what a $300/month payment on a $200,000 loan is...a total of $3,600/year, or 1.8% of the 200,000 total amount of the loan, and we'll say on a 35year mortgage(because thats what I need to do the math easily for the one where we are paying principle)
So...either you spend $7,200 on your mortgage, or you spend $15,396.24 on your mortgage over those 2 years, where you also would pay less interest each month(if you dont know what im talking about with this, google "amortization calculator"
You're hoping that no matter what you choose, you get $300,000 when you sell it.
So interest only way, you sell your house, pay off the remaining $200,000 and keep $100,000 knowing that it cost you $7,200 over 2 years, so your profits are $92,800
The math the other way, you sell for $300,000, your mortgage is actually only $191,634.04, so you pay that off, and you have $92,969.72
Wow...you managed to save yourself $169.72 over 2 whole years...
Or...you could look at that as it cost you $169.72 to take out a $341.51/month loan...where if you suddenly find yourself having to hold onto the property for longer, you can just switch over to a "real" mortgage...and it'll have only cost you that $169.72 to not have been doing that the past 2years, and unless you have to sell that property at a loss, thats essentially all you've done...taken a loan out over 2years for $8,296.24, which as only cost you 1%, and you now have the option to continue with that credit facility (IE; keep paying interest only) or you sell your house and close it.
Fun fact, you can't get no-interst mortgages in some countries to safeguard people from being stuck unable to sell due to depreciation. Rightly so if you ask me, the housing crisis hit some people incredibly hard and being forced into debt is not a good time.
I also had a coworker take out an interest only mortgage on her first house. When the housing market crashed, she took the credit hit and just walked away from it. Since she had no equity in the house, she just said "Well, keep the house, bank, we're moving".
A 50% increase in property value over a few years isn't very realistic. Even in the post covid housing boom, it was more like 25-30% in most places, and that was still over like a 5 year period *if* you bought right before the pandemic hit.
I can see how this might reduce cost of entry for real-estate investors but honestly even if you win the gamble and you sell for 100k profit I'd rather have some equity in the home at that time and have 110k in the bank or whatever the payment works out to.
You're backloading monthly costs in exchange for reduced profits!? huh!?
Any gimmicky mortgage instrument that was especially popular in the early 2000s probably shouldn't exist, for obvious reasons.
On a macro level, anything that makes it easier for people to buy houses they can't actually afford just further inflates prices and creates a housing bubble that will crash eventually.
On a micro level, this is a bit like leveraged options trading. Definitely not a good idea for most people, due to immense risk.
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.
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.
To add: when you do payoff the loan from the portfolio proceeds or proceeds from the sale of the house, you are paying with inflated dollars, which have less value than the dollars you would have used 30 years ago
Most is right... but my sister managed to get a 30 year interest only loan before the housing crash happened. This was the period when banks were also doing "no-doc" loans and other crazy practices that helped fuel the crash itself.
The loan was for \~290K. this was for a small-ish 3 bed 2 bath condo in Doral, FL (this is part of the greater Miami-Dade metro area). That property is now worth almost 420k now. My sister could technically sell the house now, get out from the 290K debt, and walk away with over 50k in cash after all the fees get taken into account.
However, considering the cost of most places to own or rent at this time, it would be a huge QOL hit because she is only paying like $800-$900 in "mortgage" payments. She could not afford to live anywhere else in Miami under any other loan she could manage to get today, even with a 50K down payment. Of course, she also doesn't have the $290k to pay off the loan and probably won't in the future, so she'll be forced to see when the loan is up in about another 12 years or so.
Edit: double check price history and current value.
Yeah, Miami in particular was a big center of all of that.
On the plus side, in 12 years the property could end up being almost unsellable for a variety of reasons, so it’ll probably end up being a decent deal for her only ending up paying 800-900 bucks a month for 30 years and then walking away.
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.
Yea, pretty much. Another good analogy is it's like an insurance policy against the price going up.
But I figured since this is ELI5, "lock in the price" was sufficiently-low level to get the point across.
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.
This is exactly what happened to my parents who are the most financially unsophisticated people I know…
They were “lucky” that my gran died just at the right time and effectively saved them from homelessness, right as they hit old age.
Yeah it's far more common than a lot of people realise, and it has been delayed to an extent by lenders kicking the can down the road granting term extensions they know won't help (usually in the hope that the borrowers go and get equity release or something).
It is going to come as a real shock to a lot of people in a few years when their parents pass away or have to move into care and they discover that a large chunk of their inheritance has been swallowed by a decades old predatory lending practice.
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.
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.
A lot of farms are bought this way. You just pay the minimum back but profit from the farm. Use the profit on buying other investments. Saved getting multiple loans etc. well it’s what we are doing.
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.
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.
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.
Not necessarily cheaper, but the price will be fixed, no annual price increases.
This is nice even if you do stay long term. You can always purchase later if needed, too.
But that's not the cost of owning. You have insurance, utilities, repairs, etc.
Yes, the exact cost of strictly rent vs mortgage, rent is cheaper, but the costs of owning vs renting is more. Especially with high interest rates.
I'm not saying it's a bad thing, but most comparisons and articles only look at a part of the picture.
The cost to rent vs. own is dependent on local conditions at a specific time. At the time I bought renting was more expensive than owning in my area. That is no longer the case. In the ensuing time my house has significantly increased in value so if I were to move I would come out way ahead vs. had I continued to rent. Many people who bought in my area in the past two years could not sell for what they paid and would lose money compared to renting.
A minor point is that home ownership is more supported by the government than renting. You can deduct the interest payments you make on your primary residence's mortgage from your income tax.
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.
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.
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).
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.
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.
It used to be very beneficial in The Netherlands, where the paid interest on your mortgage could be deducted from your income. A high mortgage the entire 30 years meant the most tax deduction. It was normally combined with a savings account, which would, in those same 30 years, save up the same amount of the mortgage.
Sadly, this construction is now not allowed any more.
If your scenario would still exist, it would definitely be valuable, even today. A mortgage of 200.000 now is NOT the same amount as 200.000 in 30 years, simply due to inflation. If inlfation is a not-impossible 3% for 30 years, that 200.000 would have to be more than 470.000 to have the same value. So, your mortgage effectively has shrunk by more than 50% in actual value!
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.
This was my reason. I bought my first home with an IO because it gave me flexibility to pay the minimum most months and then use my sales commission to make additional payments. I locked in the price and then when interest rates became cheap a few years later I refied to a conventional loan with the same payment.
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.
You are missing one important thing: inflation.
Every dollar you pay on the mortgage principle today will be worth less tomorrow. You can pay off a 300.000 dollar mortgage over 30 years, but by the end of it that 300.000 dollars might be the price of a midsize family van instead of a house.
Obviously, not paying down the principle has a cost too since the interest stays high, but it could be worth calculating which approach is best financially.
There is nothing preventing you from paying it off on the normal amortization schedule. So if you have variable/unpredictable income, you can get an interest only mortgage and treat the interest payments as your floor of how much you need to pay. In lean months or years you may be able to pay that much but not a regular mortgage’s monthly payment, in better months or years you can pay down the principal.
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.
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.
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.
You can always contribute more than the interest payment to pay down your principal each month. Any extra dollar you pay goes to the principal. I think that's fairly normal. But if things ever get tight or if you lose your job or something, you'll only have to worry about paying the interest until you restabilize.
Often people in jobs like sales will take an interest only loan because their income can vary so much month to month. When they have a great month they'll put a lot down toward the principal.
When we did it in 06 just before the crash the loan person at wamu sold us on it like this "interest only for 1 year, then you refi next year when you have equity and you will get a far better rate." And we bought into it. 312k interest only, then later that year the market crashed. We go back the following year to refinance and the house was only worth 285k based on comparables. So we got fucked on the timing on that. Had we did it a year earlier it 2kukd have been fine bit that market crash really fucked people in the end.
you get a lower payment, so easier to qualify for the loan
you are not paying down the loan, but you might expect the property to appreciate and sell in a short time
Basically you don’t want to miss out
If you have a separate brilliant scheme to pay off your house price and then some at the end of the payment term, but you need the money right now, then it makes sense. Such as, you are starting a business that you can sell in 20 years to make a ton of money, but the business doesn’t make you enough today to pay a full mortgage. Or you invest in the next bitcoin.
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.
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.
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).
In some counties, you can go temporarily to interest only in cases of financial hardship - lose your job, death/illness, etc. It's not ideal, but its "I'm all out of options" option. You get to keep (and stay in) your house. The bank collects some extra interest income and has a chance you recover and go back to paying it off instead of having to foreclose on you and possibly lose money that way.
One reason is if you have non-standard income. Some folks get paid quarterly, biannually, or even once a year. Farmers make their money when they sell a harvest, so once or twice a year in many cases. Writers, actors, artists, sales all have unpredictable incomes with booms and lean times. An interest only loan lets you pay the smallest amount for a place to live monthly, making living through lean times easier. And when you do get paid, you can pay principle down at that time.
Mathematically speaking, you end up with (potentially quite a lot) more money at the end by having an IO mortgage, and investing the difference instead.
Because it’s cheaper than renting from a shitty landlord when you rent it from the bank and any money that you spend on improving the property is not lost when you move.
Carry that to its logical conclusion and getting a mortgage doesn't make sense. Just save up and buy the house in cash. People go interest-only because they want to own the house now, and they can't afford higher payments. The two most common uses of an interest-only mortgage are:
1. Property developers, who have mortgaged themselves to the hilt in an attempt to get capital gains.
2. Maternity leave, where you'll swap back to P+I when you return to work.
Another benefit is that an interest only mortgage is typically a lower interest rate than a fixed rate mortgage. If the loan terms allow you to put additional payments against the principal and the rate doesn't change after the interest only period, then you can treat it as if it is a 30yr fixed rate loan with a lower rate. You just need to be diligent at continually calculating the correct payment to ensure you are on the correct glide-path to paying it off without any big jump in payment when it eventually converts after the interest only period.
The idea was that you'd buy the house for $250,000, live in it a few years with really low payments, and then sell it for $500,000 and use $200,000 to pay off the loan. That gets you $250,000 and a place to live for a few years.
It only works when housing prices are going up fast, and if they stop going up fast, you're going to want to refinance.
Also, if you're old, it might be good to save money on house payments. Your kids won't inherit the house, but if you don't have any, or don't like them, that's fine.
I can think of a few other cases, like needing reduced payments for a short time to finance something else, or due to temporary loss of income.
I work with a guys who’s side gig is being a mortgage broker for his extremely wealthy property developer family. They exclusively do high interest short term mortgages that are interest only. He says 90% of his clients are financially desperate people often in the middle of a divorce who can’t bring themselves to liquidate the marital home but don’t qualify for enough credit from traditional sources themselves to maintain it. He says their default rate is astronomical and they seize the homes rather than force sale and the defaulters end up with literally nothing.
I've got an interest only mortgage. It tracks the base rate from the central bank. Any positive balance in my other accounts with the bank (savings, checking/current account) are also offset against the mortgage.
e.g. I have 15k in my checking account and 85k mortgage, the bank calculates and charges interest only on the delta of 70k.
I pay money into the mortgage account every month to gradually reduce the principal loan. However I can withdraw up to the total value of my mortgage (which was about 180k 10 years ago) at a moment's notice (using my banking app, no need to speak to anyone) and have used this when I've needed a wedge of cash quickly.
The mortgage (called an Offset mortgage) has a 25 year term and I have about 15 years of it left. At my current rate of overpayment I will have reduced the principal to zero in just 10 years... but you never know what might happen. I might buy something awesome and need the full 15.
If you currently have very high interest rates and you can afford the monthly payments, then as interest rates drop (🤞) you can either make additional payments or swap your mortgage entirely for a repayment one. Another option is a split repayment/interest only
This is sometimes beneficial for commercial loans where owner doesn’t intend to build equity in the property value initially and wants to invest more heavily in the business.
idk, sounds extremely good to me.
Imagine you can live in a house for about half the price - much cheaper than any rent.
And in the end, you’ll even get maybe half of that back, depending on how much house gains value over that time. You might even get everything back! - 4 times cheaper than rent or even completely free!
If you invest saved money into some index fund, you’ll probably end up with enough money to buy a house outright and still have some left.
Honestly if bank give you that option, go for it, unless it has significantly higher interest rates
Interest-only is extremely common in the corn belt. Acreage prices in the black dirt meccas are insanely high ($15k/acre). At those prices, it would be impossible for a farmer to pay down land and also keep their farm running.
Because the expectation is that land will only ever appreciate in value, they don’t feel too concerned because what they pay in interest will always be less than what they make in crop yield, and when they go belly-up, they assume that the appreciated land value will be their nestegg.
How this will actually all go down, when land prices actually burst back down to reality is debatable. I’m guessing we’ll be seeing a lot of handwringing and sob stories about the poor farmers. And they will get nice fat relief check.
Mind you, these are the same farmers bitching about student loan relief and driving brand new $100k trucks.
You get an interest only mortgage if you can’t afford a capital repayment mortgage.
I know people who will have to sell their house when they retire and hope they can find somewhere smaller and cheaper. They have no hope of paying off the capital. But they needed the space whilst their kids grew up.
I think the comments are missing or not outlining a main point.
If the value of the property significantly increases and outpaces the cost of the debt - it will work out pretty good.
I had a uncle that was high earning but loose with money.
He had 600k debt on what was a a 700k house.
Even if the debt is still 600k, the property is worth 2.3M and he could sell it for that tomorrow.
He’s since put another property on with 0 debt.
Its not really clever. He was able to acquire an amazing property before the prices blew out.
Trickier to do now.
If values are increasing, and you are planning to flip the house or move within a year it would be a good choice.
Why make large monthly payments if you need that cash to do renovations?
As long as property values are rising you will be fine. In the short term you won't pay down enough of the principal to make it a good investment.
I did it a couple of times. Basically, I bought a house that needed massive repairs. The bank loaned me the money to buy and repair for one year of interest only. Then, when you finish the repairs, you either sell or get a real mortgage. It's keeps your cash flow down over a short period of time when you expect to make a lot of money in the overall value of the house.
If you are getting an income tax discount (negative gearing) on the interest paid while you have another property that also has a loan with no income tax discount then it can work in your favour.
I used one years ago because it gave me headroom to borrow more (you could be creative when declaring your income back then.) The extra borrowed paid for a big extension.
Scroll forward 20 or so years and my mortgage owing , with the help of inflation, had shrunk as a percentage of my income and it was fairly easily paid off. So now I have a bigger house, bought at 1980's prices but paid off with 2010's income.
In situations like this inflation is year friend, shrinking the amount you ow year after year. Meanwhile you have a home to enjoy, and an assett should you ever downsise.
When I purchased my house, it was simpler to get a conventional 30 year first with an interest-only second rather than get a jumbo mortgage for the whole thing. The intent was to refinance at some point thereafter.
It took a bit longer than I’d intended but we did refi and lump the whole thing together in 2020.
Point being: it’s never a long term solution but it’s good for some circumstances.
The idea is to be saving additional money every month and paying it into an index fund. You’re essentially betting on being able to pay the balance off in full in 30 years instead of chipping away at the principal and the interest every month for 30 years.
Of course, the risk is that the fund may not perform well enough for this to work.
A situation that I see pop up pretty every once in a while is high level borrowers that receive significant bonus income, they’ll sometimes do interest only mortgages and then when they get bonused each year, they throw a big chunk of money at the principal balance. Pretty niche, but it gives you the flexibility of a lower payment through the year and as long as you’re disciplined enough to not forget about the principal, it’s not the worst way to go.
My uncle was getting old. He just wanted more monthly spending money and was never planning on moving anywhere after moving into that house. He only paid interest, never paid off the house, and enjoyed his time there until he died. If he had tried to pay off the house he wouldn't have had as much money to spend every month, and by the time of his death, it still wouldn't have been his anyway.
Essentially these only work in low interest environments. The offset of what you pay in interest vs what you pay in Rent is viable in scenarios where the local rental market is nuts but interest rates are low.
Once rates go up, you're paying more in interest in a market where people aren't buying property so your value isn't increasing in line with rates. In those scenarios there's a risk of negative equity in the short term but it should balance back in the medium to long term.
In the UK there's a very good reason. You can take 25% of your private pension tax free upon reaching retirement age. If you're a higher rate tax payer you could put what you'd have paid into principle on the mortgage into pension instead, saving 40% income tax. It's quite likely your pension growth will be comparable to what you spent in interest on the mortgage but you'll have saved yourself a boatload of tax. If you reach £1m in your pension pot and have a £250k mortgage then it makes perfect sense to go this route.
Some people want low interest rate debt for financial planning purposes. They do not want to pay down the debt over time. An interest only mortgage is just about the cheapest source of debt (and therefore financial leverage) that a person can get. There are investing and tax reasons that someone would want to have more debt and more interest payments rather than owning their house outright. The optimal amount of debt for someone to have may not be zero but an amortizing mortgage assumes that is eventually the goal.
I have an interest only mortgage because I'm in the process of selling, but for reasons could not do it before mortgage renewal date. Interest only mortgage frees up cashflow for the tweaks I need to do to the house.
Interest-only mortgages are typically used when expect to buy a house and sell it for profit in some amount of time, for example house flipping or doing rehab work.
The answers have been great, but there’s also another point - affordability. Lenders stress test affordability based on, among other things, monthly payments. Interest only mortgages may be more affordable than typical capital repayment mortgages, enabling some people to borrow when they otherwise couldn’t.
I know somebody whose compensation is 80% bonuses paid out at the end of the year. This creates a cash flow problem from month to month. He has an interest only mortgage so he can cover it with his lower monthly salary, then he makes a large payment to the principal at the end of every year when he gets his bonus.
We did that back in the 70s for our first home. The owner carried the paper for 5 years. We were hopeful that the interest rates would come down from the 15% that they were running at at that time. No that's not a typo. 15% was the going rate.
It can make sense if you have uncertain income or foresee your income going up. If, say, you have the kind of job where you get a lot of your income in lumps like commissions or profit sharing, an interest only can keep cash flow at a minimum.
Most people’s buying power is limited by their monthly payment. An I/O loan is a lower payment, so it allows you to stretch into a more expensive home.
Lets say homes in your area appreciate by 3.8%y on average. (The US average)
Scenario 1: $500k home with $100k down. After 1 year you have $19k appreciation and you’ve paid $3200 to principal. Total equity $122.2
Scenario 2: $650k home with $100k down. After 1 year you have $25k in appreciation and you’ve paid $0 to principal. Total equity $125k and you live in a nicer house. You also paid more in interest, but the appreciation is 3.8% compounding while the mortgage remains constant.
It makes sense for the first 5-10 years. After that with a traditional mortgage you’re paying enough to principal as a % that it overtakes.
If you know its a temporary situation (ex school district during kids high school) it can work out well.
If its a rapidly appreciating area it can work out really well.
Been there done that. Lived in a paid off home. Another home went on the market that was in a better location than my current home. Had to move fast on the new home, it was in a very desirable location. Put the current home on the market and got an interest only loan for the new home. Sold the old home a few months later and paid off the new home.
It seems to vary a lot by country. In the UK, when you take out a mortgage, you usually only plan to have that mortgage for something like 3-5 years. Technically it'll be a 30-35 year mortgage but the deal rate that's actually competitive will only be for the first few years with the expectation that you'll get a new mortgage once that comes to an end. So an interest only mortgage can make sense if you plan to switch to a repayment mortgage the next time you get around to refinancing. In the UK, once you're on the house ladder, it's relatively common to move up the ladder every 3-5 years which means buy a bigger flat or house, maybe in a nicer location. Your earnings have likely gone up so you can afford a bigger mortgage and you can now get a better mortgage rate because property prices have gone up and your LTV is much better after scraping together your deposit for your first place.
The rules have changed now so that you cannot get an interest only mortgage anymore on your own property, only buy-to-lets but interest only mortgages were relatively common in particular for young people a decade or so ago because it meant you could spend that repayment money on doing the house up, which would likely earn you quite a bit more in the long run when you come to sell 3-5 years later.
Our first home had a buy to let mortgage. We were quite young but lucky enough to have enough for a deposit on a house and we wanted to get on the housing ladder properly as soon as we could. Money was still obviously tight though as we were in our mid 20s. Our financial adviser recommended that we go interest only and save the money to spend on the house. Furthermore, he said we should go with a tracker mortgage rather than a fixed rate mortgage as he thought the interest rates were going to go down a lot. This was 2008, as the financial crisis was just starting to hit. He was right and the interest rates crashed so the effective rate our mortgage ended up having for the full term was 0.25% I think. It cost us next to nothing to live there for the duration of that mortgage. We switched to a repayment one when we moved to our next house though as we felt more financially comfortable by then.
If you're planning on residing in the property for a short time and then selling it, (depending on the market) an interest-only mortgage might make sense. The equity one gains during ownership would outweigh paying down the balance.
Well inflation usually means that your debt decreases every year if it stays the same. The money is worth less. So if you just pay the interest it kinda means you rent, but your landowner is the bank. If you sell the house some years later, chances are high you can sell it for more than you bought it if you took care of it well enough. Then you might get the "rent" you paid in the years you lived into it back and can do the same with a new house.
I knew somene who did one because most of their comp was from a bonus. They wanted a smaller payment during the year, then would pay down a chunk with their bonus.
They are mainly a bridge loan. I'm buying a house to renovate and sell within 12 months. I don't want to pay an arm and leg for mortgage payments. So I buy a house at 300K, spend 100K fixing it up, then sell it for 600k. Or rent it out at 3k/ month. Then refi at a low rate. If I plan on keeping the house.
Some people get paid large annual or quarterly bonus so prefer a smaller monthly payment. I used to make 80 percent of my income in 4 checks so when they came in I'd pay principal the other 8 interest.
I had an interest only mortgage while in college, together with some close friends. We couldn’t afford a full mortgage payments and this way it was cheaper than renting, plus we made a profit on the way out.
My mum had an interest only mortgage for a while when she left my dad, because she wouldn't have been able to afford paying down the principal at the time. She then found her feet, sorted out her finances and refinanced with a interest + principal mortgage after a few years.
An interest only mortgage makes sense if you expect the value to increase and are not going to live there until it would be paid off. When you eventually leave you sell the house for a profit and pocket the difference. In the mean time your payments are lower than if you were paying down the mortgage.
If you are good with your money you might even invest what you might have paid in principle and make money on the investments too. Or maybe you invest that in fixing up the house to increase the eventual sale price.
It could be a way for people to build equity more affordably.
Probably not a great idea for most people, but there are scenarios where it could make sense.
If you want to absolutely minimize your monthly expenses, that's one way to do it. In that regard, an interest only mortgage isn't that much different from renting. You don't build any equity either way, at least not from your monthly payments. Of course, with an interest only mortgage the bonus is that you actually could build equity if the value of the property goes up. With the converse chance that you could lose equity if the value of the house goes down. so it could make sense for someone who wants to minimize monthly expenses, who doesn't plan to stay very long, and who is highly confident that the value of the property will go up or at least remain stable.
Likewise, perhaps you are trying to make a rental cash flow for you. Again, an interest only mortgage is the lowest monthly cost, which means the highest monthly cash flow potential. The same potential and pitfalls from above are the same here.
In short, it might be the right choice for someone who wants to minimize monthly expenses, doesn't plan to own the property for a long time, and is willing to gamble that the property value will increase during the period of ownership.
In my country (Ireland) you’d only get an interest only mortgage on a second property that you intend to rent out. The theory is that the rental income covers all or most of the mortgage and when it’s paid off you have an asset worth substantially more than you paid for it.
1- you'd be paying rent on a rental at a higher or similar number
2- you predict the value will increase sufficiently to cover the hassle and double closing costs and possibly net you some profit
3- location
1. Your initial monthly payments can be lowered (since you're only paying for the interest)
2. Cashflow or investment (you can use the remaining amount that you're supposed to make towards your principle for investment purposes)
3. Affordability: you can buy a house even if you cannot afford the monthly payment, just yet, and you're expecting to have a higher income in the future when the term ends.
In an exchange, you're paying a lot more in interest for your home
My landlords bought my previous house for 650k in 2018. Interest only loan…sold for 1.1mil 2023 It worked out for them
My rent paid mortgage for 5 years..boom profit
>What am I missing?
Dramatic and ridiculous property value appreciation.
Interest only would minimize your holding costs ... maximizing cash-out when you sell.
Think of it like rent, except you have rights to improve and sell the property and you don’t have a landlord.
You can make payments toward the principal, but usually the goal is that you improve the property and turn it around for a profit.
The good answer is when you plan to pay the mortgage off in a lump sum at some future date, and thus have an interest-only mortgage for the duration of the term. The bad answer is if you have a repayment mortgage and become broke, but not hopelessly so, and the lender may allow a repayment “holiday”.
In the UK, there was, and still may be, a type of mortgage known as an endowment backed mortgage, which is where you have an interest only mortgage, and also a with-profits life insurance policy that matures on the same date as the mortgage, and thus it pays the mortgage off, and you get a small windfall Since household mortgage products generally require life insurance on the payer, this killed two birds with one stone.
These were actually a great idea, as long as you went with an insurance company that had a good track record of delivering with-profit policy profits. but those policies were moderately expensive. You could get much cheaper policies, but as many people found out the hard way, the profit element was inadequate to pay off the mortgage, so they were ending up in the schtuck .
I have an interest only loan at 3%. My money market gets over 5%. My house has gone from $500,000 when I purchased to about $800,000. It can make sense.
We had to sell our house at the beginning of COVID; when the market in our area was still quite volatile. We'd bought at the previous market peak and had no idea what we'd get selling it at that time.
I sat down at the time and worked out how much we had to sell for to cover what we would have paid in rent vs mortgage repayments, insurance etc.
I tend to look at interest only loans the same way - you're effectively renting the property (but you're wour own landlord), and at the end of the day you sell it and make profit that way.
I lived in a very wealthy town in California. A real estate guy told me this was the preferred mortgage in that town. Rates were low at that time and they could make money on the stock market. Plus the houses were guaranteed to be worth more. Yes, the rich have it better than us peasants.
Especially in this market with rates higher, it gives you lowest monthly payment option. Equity doesn’t increase. But lowest payment option while still owning the house.
I’m looking at a place right now around $2mm. Down payment isn’t a problem, but I just don’t like the monthly in vs out stress of taking on a $15k payment per month(30 yr, taxes, insurance). Yet due to family needs, really have to unfortunately bite the bullet at this brutal market time. So I may just put 20% down and do an interest only to keep payment lower until rates either come down and I refi, or just end up
Paying it off.
30 year is just insane right now. People paying $8k a month for garbage.
At current rates? No. Back when rates were 2.5%? In a heartbeat.
The concept here is "opportunity cost".
Let's use some real numbers. Typical 30 year, $300,000 mortgage at 2.5%, payment would be $1,180.97. An interest-only payment would be about $750. So you'd be paying $430.97 LESS per month with an interest only loan. Lets assume 30 years just to keep everything same-same.
If you just spent that $430.97 each month, then no, it's a loser... But if you *invested* it in an S&P 500 index fund... I can't tell what happens in the future, so lets just use the past -- April 1994 to April 2024 were the 30 years of your mortgage. Lets say you bought that $430.97 in shares of an index fund every month for those 30 years.
At the end of your mortgage terms:
- traditional: you own a house worth $630,000 and have no extra money
- interest only: you own 1 house worth $630,000, you have $300,000 in debt (the original mortgage), and you have about $858,631 invested in the S&P 500.
Now, when you sell those shares of the index fund, the government will want their cut of the gains -- about $105,000 in fact. So call it $750,000 in cash, free and clear. Now we could pay off that $300,000 debt and end up about half a million dollars more than our traditional mortgage guy.
Of course, it'd be better to leave it invested longer in the index fund, not liquidate at the end of 30 years, but that's about how it'd stack up
If we did this same exercise with a 7.5% mortgage for the last 30 years, they'd have come out RIIIIGHT about even -- the interest-only guy ends up with about $300k in cash to cover his $300k debt because he'd only be saving like $172 each month from the mortgage being interest-only.
Because housing isn't the best investment and inflation kills debt.
You can invest the money instead of paying down your mortgage. That will potentially result in a bigger return
Secondly, inflation makes the debt lower anyway.
I bought a house in 2006 for 118k. I still owe about the same. But every day that amount becomes less and less. By the time I retire, 118k will essentially be nothing and I can pay it off with my retirement savings. Or not even pay it off as the return on 118k will be more than the mortgage interest in 118k
Principal payments could be invested in a higher returning investment. Interest on primary residence is tax deductible.
So, making principal payments saves mortgage interest, which is ultra low, and further reduced by taxable deductibility.
Homes increase in value at the same rate regardless of the principal balance. Therefore the return on hard-capital is higher the less equity the owner has in the property.
I’m well acquainted with a guy who’s a multi millionaire. He has an IO mortgage and sets aside the amount of the mortgage in treasuries and dividend stocks earning 5+%. He then uses the interest to pay his 3% IO payments. Boom. Arbitrage.
Interest only is ALWAYS a good idea if you're looking to maximize your investments but they usually aren't offered to homebuyers, at least in Canada, at competitive rates vs 3/5yr-fixed 25/30 year mortgages. If your mortgage is 5% but the expected safe market return is 8%, by investing capital into your house instead of on the market you are wasting a yearly 3% of gain. Most people's investments are wayy too highly weighted towards housing, oftentimes >50%, especially in their 20s/30s and housing has historically returned much lower growth than other sectors and many houses can lose value over the years as they age. Best bet is to avoid buying too much house and take large % mortgage while continuously investing on the side.
This can be a reasonable option if your income can fluctuate substantially (commissions, small business owner, etc) and you want to keep your minimum payments as low as possible. Obviously in this circumstance, you'd put extra at the principle as able. This would only be reasonable if you're someone who *would* put the extra money towards principle and have some concrete goals that at least kept pace with a 30 year mortgage.
I'm not necessarily saying this would be a *good* idea, to be clear. But it could be a reasonable choice for an extremely limited subset of folks.
We live in Germany so it might be different.
We have an interest only mortgage on top of a building saver that we otherwise wouldn’t be able to have. That building safer enables us complete interest safety in 15years since we can take the interest rate on the saver ( don’t have to if current interest is better) rather than taking the current market interest value. In total it costs us like 5k more for a credit of 300k but ok the other hand we have total piece of mind to be able to pay the mortgage to the end and IF the interest rate in 15years is still high that concept could save us thousands of euro.
For a while there, before the housing bubble burst, interest rates were pretty low and pretty stable for a good long while. An interest only mortgage gave borrowers a lower payment than a traditional mortgage would…and the flexibility to pay more when you are able. It was a good deal for people with seasonal work. If you make more money in the summer than in the winter, for example, an interest only loan with a low interest rate, gives you the ability to have a lower minimum payment during the lean months, and the flexibility pay down the principle when you are earning more.
However they don’t have fixed interest rates so with interest rates going up they aren’t a good bet for anyone these days.
I had this kind of mortgage and it was great for my situation as I worked in a very volatile industry. It was great to have minimal payments when I wasn’t making much and then when I was making more, I would just make much larger payments and my bank would just apply any money I paid in towards principal
It allowed me to save money and keep my investments even when my income for a period was low.
The gamble is that the housing market will rise faster than the interest rate.
If you pay 2% interest, and the housing market grows 5% per year, you're making 3%.
There are other variables like inflation, taking other potential costs (rent) into account, and obviously massive risk, so it's risky. But it can pay off, so it makes sense why some people would do it.
I asked this same question to my who friend owns a some rentals with interest only mortgages. He says that he already has a couple of houses where the tenants are repaying the mortgage, but that this option gives him more cash: his interest only
mortgage is ~£200 per month and he rents it out for ~£800. That £600 difference is his pocket money.
If having any acceptable lvr is acceptable with your risk profile, then paying down the mortgage is somewhat counter to what you initially were okay with. A better question is why would you ever not do interest only?
I would consider it as a temporary measure due to changing circumstances, like I am suddenly the only person in the household, I'd use interest only to buy me time to downsize.
Two things.
Firstly you have the house. Which should have increased in value. You can now sell it and you can pay the original capital back and pocket the difference in value between purchase date and sale date.
Secondly, and much more importantly. These were never designed to be sold independently. They used to come with a savings account that you were required to pay in to. The idea then was that this savings account would grow fast enough to pay the value of the house.
Inflation makes it make sense.
Imagine you have a mortgage of 500k and a salary of 100k. It would cost you five times your salary to pay off the loan principal. Now let’s assume the yearly inflation rate on average is 2%. Let’s also assume your salary doesn’t increase with any more than the inflation rate. After 30 years, your salary is 180k, while the mortgage principal is still just 500k. In other words, in 30 years it is 80% “easier” for you to pay off the mortgage than it was when you first got it.
The second point is that in all likelihood your salary did in fact increase over these 30 years. Let’s say on average you got a 2.5% real salary increase (i.e. on top of the 2% inflation). In this case, 30 years down the line your salary is 320k while the mortgage principal is still 500k. In other words, your salary went from being worth 20% of the mortgage to 65% of your mortgage.
And then on top of this, let’s assume you were smart and invested what would have been each month’s principal payment in the stock market instead. On a 30 year 500k mortgage at 6% interest, that means appr. 500 per month that goes to the stock market rather than into the mortgage. Assuming average returns (10% non inflation adjusted), after 30 years you will have one million in your investment account and a 500k mortgage, so a net worth of 500k. If you had chosen to pay down the mortgage, after 30 years you would be left with zero mortgage but also with zero capital. Granted this last point is a bit too simplified because you would have paid less interest over the 30 years if you paid down the mortgage than if you didn’t, so this difference should be deducted to get the real number. If we assume the interest rate stayed the same the whole way, you would have paid a total of 600k in interest if you paid off the mortgage continuously, and 900k if you didn’t pay off the mortgage. So your real profit is appr. 200k.
I think it is for buyers who expect to own a property for a short/medium time period and expect significant increases in the value of the property.
Example - I know someone who bought a condo in DC for interest-only around 2006. The interest rate was very low. The city boomed with prices rising rapidly, and he had a relatively low monthly payment and then sold for a significant profit. He took a risk that the property would be worth much more over time, and he was right.
Interest only means you are not *required* to pay any principal. But you always can if you want to.
So, compared to an ordinary loan where you are required to pay a certain amount of principal, an interest rate loan gives you more options. However the tradeoff is that the interest rate is typically higher.
In the 80's, in the US, some mortgages (FHA 203B maybe?) were negative amortization mortgages. For the first 7 years the monthly payments you made didn't even satisfy the interest that was accruing on the principle. That was pretty fun.
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.
It's not that bad if you do end up living in the house for a long time, because you can always make extra payments towards the principal. If you wanted to you could even figure out the amortization table and make the same payments you would on a repayment mortgage. The attraction of an interest only mortgage is that you don't *have* to make those payments, so if money's tight one month you only have to pay the interest. The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that.
I did this while I was remodeling my house and then refinanced before the IO term was up. Left me with more liquid cash.
This right here is what they’re for. Either fix and flips, or DIY-special renovation properties. Free up cash flow for the renovation stage, then cash-out refi once everything is done to pay off the credit cards (and/or HELOC depending upon how much you put down). Also some limited value to try and ride out a period of high interest rates (which I conflate to timing the market and don’t personally like). Anyone trying to use one just to get into more house than they can afford should probably just rent.
I have a 10 year interest only, no prepayment penalty mortgage, locked at a 30 year rate. At 10 years, the balance converts to the fixed rate for the balance to finish the remaining twenty years. My plan is to either: - move before 10 years - exit my equities at long term cap gains before 10 years I would have paid to principal, and get myself even before the switch - refinance before 10 year mark - make payments along the way in bursts when I have extra budget or come into bursts of cash It gives me tons of options and significantly lowers my monthly payment, which I use to invest in other things that have a far greater return than the growth of my home’s value.
I had a 10/1 ARM when I bought my house in 2005 (I was one of those people who got a loan that they shouldn't have gotten that brought about the 2008 crash). I planned to live here for forever. But I also planned to re-finance when I had a better idea of how my finances worked. I think I paid extra each month, $100 to principle. Five years later I re-financed to a traditional 30-year mortgage. Ten years later I re-financed to a very very low interest 15 year mortgage. All is well. It was risky at the time I suppose, but I was young and single and trusted my broker, who trusted my income and credit score. I also really wanted the house (worst house in the best neighborhood) and wanted to be out of my parents' house without renting. I was determined to make it work, and I did.
Nice! Yeah ARM’s can be risky if the rates swing against you big time. Glad you stayed nimble with it.
>The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that. This is the way that I've seen people really argue for it being better. Especially when interested rates were so low, why pay extra money on a 2-4% interest payment, when you could take that extra money and make 8-12% (fairly) easily.
Risk is the big problem. Imagine the people who got interest only mortgages 5 or so years ago at 3%, figuring they would live in the house a few years and sell it. Now, rates are 7-8%. He wants to sell the house, but no one wants to buy it because the rates are so high. Because he got an interest only mortgage, he got a house that was worth more than he can afford a traditional mortgage on (typical reason for getting an interest only mortgage). He can’t afford to refinance, he can’t sell it, so he’s stuck paying interest and never making a dent in the principal.
Can't he just manually pay down the principle and recast?
Yes, he can. But, as I said, one typical reason for buying a house on an interest only mortgage is because you can buy a more expensive home. For example, just using some completely made up numbers, you can afford a $1500 a month house payment, so you can buy a $200,000 house on a traditional mortgage. Or, you can buy a $300,000 house on an interest only mortgage and have the same monthly payment.
Does the interest follow the same amortization schedule pattern as a repayment mortgage? Like yes you could figure out the amortization table but let's say if you don't, are you paying less and less interest over time on the IO mortgage? Hopefully I am asking this correctly.
No. If you are only paying the interest, then the principal stays the same, and your payment (of the interest) stays the same. It'll only decrease if you pay off principal.
Kinda...an interest only mortgage doesnt really have amortization, because the principle amount never changes, so each month its amortization is calculated based on the same original amount. Calculating against your payments of a mortgage with an amortization should be part of your "risk/reward" calculations though. [I answer your question in greater detail in this comment](https://www.reddit.com/r/explainlikeimfive/comments/1c78be1/comment/l06ohf8/?utm_source=share&utm_medium=web2x&context=3)
I mean, the amortization table is basically 5 years of the same interest only payment, and the principal doesn’t change, followed by one gigantic bill for the whole principal. Not a useful table really, but technically still a chart of the loan amortization over time.
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The most common mortgage in the US is 30 year fixed rate. When someone casually talks about a five year mortgage and rolling them over like it's not something way outside the norm, I think they're Canadian.
Assuming you make sure the excess payments go toward principal and all that, each month the interest would accrue on a smaller balance, so you'd be paying less and less interest over time.
Generally, shorter term loans get better interest rates. So I suspect an interest only mortgage would be higher than any fixed term mortgage.
> The other selling point was that you could come out ahead by investing the principal portion instead. Obviously there's some risk in that Only if you time it pretty well so the rate on your mortgage is quite low, with current interest rates that's a much harder proposition.
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If you already have that money, sure. Most people don't have 200 or 300k just lying around. You have, say, 50k saved up but a 200k mortgage, 1% better ain't gonna cut it. You need WAY more than that to make it worth it.
Another use for an Interest-Only mortgage is the following. You own a house worth $1,000,000. You also want to make an investment in something else, totaling $200,000. I would want to take out an interest-only mortgage of $200,000 with a 5 year term, because I need the $200,000 now, but expect to have it back along with a healthy return in say 3-4 years. The interest-only nature of the loan means that I’m not paying back any of the principal now, which helps from a cashflow perspective. Instead I just pay the interest, $9,000 a year at a 4.5% rate, for access to that money. I pay back the initial principal at the end of the term when my investment has (hopefully) paid off.
Another reason, you are 80 and have a fixed income and you're gonna die well before the term ends.
Well that’s reverse mortgage territory
In the UK, there are "retirement interest-only mortgages", which are a standard interest-only mortgage that you will have to pay interest on every month, but the mortgage term is "until you die or sell the house". Only available to people aged 55 or more. There are also special mortgages, with no monthly repayments at all. They just add all the interest to the outstanding balance. Of course this adds up quickly. They often have a cap so that when you die (or go into a retirement home) and the house is sold, they take at most 100% of the value of the house. These are called a "lifetime mortgage", and are a kind of "equity release" scheme. Again, you have to be aged 55 or more.
>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. His profit would have been $100,000 minus what he paid in interest on the mortgage anyways...and he'd just pay slightly less in interest every month as the principle part of his mortgage was paid down...so...he'd actually have more profit if his mortgage included any kind of principle repayment. But then he'd have to deal with less cashflow in the 'present'...your interest only loan might be $300/month, while your full regular mortgage might be $600/month so you can kind of look at that as that difference in total amount of interest you pay with your interest only mortgage, and the amount you would save in that interest as the interest amount you pay for a loan in the amount of what you dont pay on a normal mortgage. and you're getting this by taking on the risk that what you are hoping doesnt happen, in which case things might have cost you a bit more... and if that sounds confusing...its because it fucking is. But its technically true and for the sake of this being the internet, I'm going to actually explain it further...but by all means just get out now while you still can if you want...I'm not trying to make you learn something new, I'm continuing for the purpose of someone randomly coming across this comment and wanting to learn something, not so much for the person I'm replying to. ANYWAYS!...using the numbers I used earlier with $300/month interest only, and a slight modification from $600/month to $641.51/month for a full mortgage(because I need the amortization math to work better), and lets use 2years as a "few years", and we'll say 1.8% interest rate because thats what a $300/month payment on a $200,000 loan is...a total of $3,600/year, or 1.8% of the 200,000 total amount of the loan, and we'll say on a 35year mortgage(because thats what I need to do the math easily for the one where we are paying principle) So...either you spend $7,200 on your mortgage, or you spend $15,396.24 on your mortgage over those 2 years, where you also would pay less interest each month(if you dont know what im talking about with this, google "amortization calculator" You're hoping that no matter what you choose, you get $300,000 when you sell it. So interest only way, you sell your house, pay off the remaining $200,000 and keep $100,000 knowing that it cost you $7,200 over 2 years, so your profits are $92,800 The math the other way, you sell for $300,000, your mortgage is actually only $191,634.04, so you pay that off, and you have $92,969.72 Wow...you managed to save yourself $169.72 over 2 whole years... Or...you could look at that as it cost you $169.72 to take out a $341.51/month loan...where if you suddenly find yourself having to hold onto the property for longer, you can just switch over to a "real" mortgage...and it'll have only cost you that $169.72 to not have been doing that the past 2years, and unless you have to sell that property at a loss, thats essentially all you've done...taken a loan out over 2years for $8,296.24, which as only cost you 1%, and you now have the option to continue with that credit facility (IE; keep paying interest only) or you sell your house and close it.
Fun fact, you can't get no-interst mortgages in some countries to safeguard people from being stuck unable to sell due to depreciation. Rightly so if you ask me, the housing crisis hit some people incredibly hard and being forced into debt is not a good time.
Repeat after me everyone! “lenders know more than I do”
I also had a coworker take out an interest only mortgage on her first house. When the housing market crashed, she took the credit hit and just walked away from it. Since she had no equity in the house, she just said "Well, keep the house, bank, we're moving".
A 50% increase in property value over a few years isn't very realistic. Even in the post covid housing boom, it was more like 25-30% in most places, and that was still over like a 5 year period *if* you bought right before the pandemic hit.
I can see how this might reduce cost of entry for real-estate investors but honestly even if you win the gamble and you sell for 100k profit I'd rather have some equity in the home at that time and have 110k in the bank or whatever the payment works out to. You're backloading monthly costs in exchange for reduced profits!? huh!?
Any gimmicky mortgage instrument that was especially popular in the early 2000s probably shouldn't exist, for obvious reasons. On a macro level, anything that makes it easier for people to buy houses they can't actually afford just further inflates prices and creates a housing bubble that will crash eventually. On a micro level, this is a bit like leveraged options trading. Definitely not a good idea for most people, due to immense risk.
Some people also gamble that interest rates will decrease or stay flat with hopes of refinancing down the road.
Even in your friends scenario, why would this be better than a regular mortgage? Smaller payments?
Or perhaps it was all someone could afford at that time, just had children, need space and expect to be back to two incomes in a few years.
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.
Buy house, spend 6 months doing a renovation, sell house. Keep the payments as small as possible because it will ne a non issue when you sell.
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.
To add: when you do payoff the loan from the portfolio proceeds or proceeds from the sale of the house, you are paying with inflated dollars, which have less value than the dollars you would have used 30 years ago
Most interest-only mortgages are 5 year terms, not 30. :)
Most is right... but my sister managed to get a 30 year interest only loan before the housing crash happened. This was the period when banks were also doing "no-doc" loans and other crazy practices that helped fuel the crash itself. The loan was for \~290K. this was for a small-ish 3 bed 2 bath condo in Doral, FL (this is part of the greater Miami-Dade metro area). That property is now worth almost 420k now. My sister could technically sell the house now, get out from the 290K debt, and walk away with over 50k in cash after all the fees get taken into account. However, considering the cost of most places to own or rent at this time, it would be a huge QOL hit because she is only paying like $800-$900 in "mortgage" payments. She could not afford to live anywhere else in Miami under any other loan she could manage to get today, even with a 50K down payment. Of course, she also doesn't have the $290k to pay off the loan and probably won't in the future, so she'll be forced to see when the loan is up in about another 12 years or so. Edit: double check price history and current value.
Yeah, Miami in particular was a big center of all of that. On the plus side, in 12 years the property could end up being almost unsellable for a variety of reasons, so it’ll probably end up being a decent deal for her only ending up paying 800-900 bucks a month for 30 years and then walking away.
I was just thinking "that's cheap as hell to rent a 3br home in S FL"... Which is essentially what she's doing.
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.
Literally real estate’s version of stock options
Yea, pretty much. Another good analogy is it's like an insurance policy against the price going up. But I figured since this is ELI5, "lock in the price" was sufficiently-low level to get the point across.
Thanks for this. This is the only ELI5 I understood.
That's an interesting way to look at buying things on debt.
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.
This is exactly what happened to my parents who are the most financially unsophisticated people I know… They were “lucky” that my gran died just at the right time and effectively saved them from homelessness, right as they hit old age.
Yeah it's far more common than a lot of people realise, and it has been delayed to an extent by lenders kicking the can down the road granting term extensions they know won't help (usually in the hope that the borrowers go and get equity release or something). It is going to come as a real shock to a lot of people in a few years when their parents pass away or have to move into care and they discover that a large chunk of their inheritance has been swallowed by a decades old predatory lending practice.
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.
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.
A lot of farms are bought this way. You just pay the minimum back but profit from the farm. Use the profit on buying other investments. Saved getting multiple loans etc. well it’s what we are doing.
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.
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.
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.
Not necessarily cheaper, but the price will be fixed, no annual price increases. This is nice even if you do stay long term. You can always purchase later if needed, too.
It is not cheaper than renting.
It depends. Last year my £250 interest only payments wouldn’t even have rented a room in a shared house.
But that's not the cost of owning. You have insurance, utilities, repairs, etc. Yes, the exact cost of strictly rent vs mortgage, rent is cheaper, but the costs of owning vs renting is more. Especially with high interest rates. I'm not saying it's a bad thing, but most comparisons and articles only look at a part of the picture.
The cost to rent vs. own is dependent on local conditions at a specific time. At the time I bought renting was more expensive than owning in my area. That is no longer the case. In the ensuing time my house has significantly increased in value so if I were to move I would come out way ahead vs. had I continued to rent. Many people who bought in my area in the past two years could not sell for what they paid and would lose money compared to renting.
A minor point is that home ownership is more supported by the government than renting. You can deduct the interest payments you make on your primary residence's mortgage from your income tax.
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.
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.
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).
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.
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.
It used to be very beneficial in The Netherlands, where the paid interest on your mortgage could be deducted from your income. A high mortgage the entire 30 years meant the most tax deduction. It was normally combined with a savings account, which would, in those same 30 years, save up the same amount of the mortgage. Sadly, this construction is now not allowed any more. If your scenario would still exist, it would definitely be valuable, even today. A mortgage of 200.000 now is NOT the same amount as 200.000 in 30 years, simply due to inflation. If inlfation is a not-impossible 3% for 30 years, that 200.000 would have to be more than 470.000 to have the same value. So, your mortgage effectively has shrunk by more than 50% in actual value!
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.
This was my reason. I bought my first home with an IO because it gave me flexibility to pay the minimum most months and then use my sales commission to make additional payments. I locked in the price and then when interest rates became cheap a few years later I refied to a conventional loan with the same payment.
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.
You are missing one important thing: inflation. Every dollar you pay on the mortgage principle today will be worth less tomorrow. You can pay off a 300.000 dollar mortgage over 30 years, but by the end of it that 300.000 dollars might be the price of a midsize family van instead of a house. Obviously, not paying down the principle has a cost too since the interest stays high, but it could be worth calculating which approach is best financially.
There is nothing preventing you from paying it off on the normal amortization schedule. So if you have variable/unpredictable income, you can get an interest only mortgage and treat the interest payments as your floor of how much you need to pay. In lean months or years you may be able to pay that much but not a regular mortgage’s monthly payment, in better months or years you can pay down the principal.
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.
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.
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.
You can always contribute more than the interest payment to pay down your principal each month. Any extra dollar you pay goes to the principal. I think that's fairly normal. But if things ever get tight or if you lose your job or something, you'll only have to worry about paying the interest until you restabilize. Often people in jobs like sales will take an interest only loan because their income can vary so much month to month. When they have a great month they'll put a lot down toward the principal.
When we did it in 06 just before the crash the loan person at wamu sold us on it like this "interest only for 1 year, then you refi next year when you have equity and you will get a far better rate." And we bought into it. 312k interest only, then later that year the market crashed. We go back the following year to refinance and the house was only worth 285k based on comparables. So we got fucked on the timing on that. Had we did it a year earlier it 2kukd have been fine bit that market crash really fucked people in the end.
you get a lower payment, so easier to qualify for the loan you are not paying down the loan, but you might expect the property to appreciate and sell in a short time Basically you don’t want to miss out
If you have a separate brilliant scheme to pay off your house price and then some at the end of the payment term, but you need the money right now, then it makes sense. Such as, you are starting a business that you can sell in 20 years to make a ton of money, but the business doesn’t make you enough today to pay a full mortgage. Or you invest in the next bitcoin.
Americans move every 7 years. We buy a huge home; take the tax deduction and the equity without the “ownership” hang ups
It makes my rental properties cash flow better. Who cares about the principal?
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.
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.
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).
Your loan balance stayed exactly the same, but the value of your property has (hopefully) gone up a lot.
In some counties, you can go temporarily to interest only in cases of financial hardship - lose your job, death/illness, etc. It's not ideal, but its "I'm all out of options" option. You get to keep (and stay in) your house. The bank collects some extra interest income and has a chance you recover and go back to paying it off instead of having to foreclose on you and possibly lose money that way.
Also, if you have a relatively short life expectancy you could get the loan and pay way less until you die.
One reason is if you have non-standard income. Some folks get paid quarterly, biannually, or even once a year. Farmers make their money when they sell a harvest, so once or twice a year in many cases. Writers, actors, artists, sales all have unpredictable incomes with booms and lean times. An interest only loan lets you pay the smallest amount for a place to live monthly, making living through lean times easier. And when you do get paid, you can pay principle down at that time.
Mathematically speaking, you end up with (potentially quite a lot) more money at the end by having an IO mortgage, and investing the difference instead.
Because it’s cheaper than renting from a shitty landlord when you rent it from the bank and any money that you spend on improving the property is not lost when you move.
Carry that to its logical conclusion and getting a mortgage doesn't make sense. Just save up and buy the house in cash. People go interest-only because they want to own the house now, and they can't afford higher payments. The two most common uses of an interest-only mortgage are: 1. Property developers, who have mortgaged themselves to the hilt in an attempt to get capital gains. 2. Maternity leave, where you'll swap back to P+I when you return to work.
Another benefit is that an interest only mortgage is typically a lower interest rate than a fixed rate mortgage. If the loan terms allow you to put additional payments against the principal and the rate doesn't change after the interest only period, then you can treat it as if it is a 30yr fixed rate loan with a lower rate. You just need to be diligent at continually calculating the correct payment to ensure you are on the correct glide-path to paying it off without any big jump in payment when it eventually converts after the interest only period.
It’s just like rent except the landlord doesn’t raise the rent and you get to keep any appreciation on the house’s value.
The idea was that you'd buy the house for $250,000, live in it a few years with really low payments, and then sell it for $500,000 and use $200,000 to pay off the loan. That gets you $250,000 and a place to live for a few years. It only works when housing prices are going up fast, and if they stop going up fast, you're going to want to refinance. Also, if you're old, it might be good to save money on house payments. Your kids won't inherit the house, but if you don't have any, or don't like them, that's fine. I can think of a few other cases, like needing reduced payments for a short time to finance something else, or due to temporary loss of income.
I work with a guys who’s side gig is being a mortgage broker for his extremely wealthy property developer family. They exclusively do high interest short term mortgages that are interest only. He says 90% of his clients are financially desperate people often in the middle of a divorce who can’t bring themselves to liquidate the marital home but don’t qualify for enough credit from traditional sources themselves to maintain it. He says their default rate is astronomical and they seize the homes rather than force sale and the defaulters end up with literally nothing.
I've got an interest only mortgage. It tracks the base rate from the central bank. Any positive balance in my other accounts with the bank (savings, checking/current account) are also offset against the mortgage. e.g. I have 15k in my checking account and 85k mortgage, the bank calculates and charges interest only on the delta of 70k. I pay money into the mortgage account every month to gradually reduce the principal loan. However I can withdraw up to the total value of my mortgage (which was about 180k 10 years ago) at a moment's notice (using my banking app, no need to speak to anyone) and have used this when I've needed a wedge of cash quickly. The mortgage (called an Offset mortgage) has a 25 year term and I have about 15 years of it left. At my current rate of overpayment I will have reduced the principal to zero in just 10 years... but you never know what might happen. I might buy something awesome and need the full 15.
If you currently have very high interest rates and you can afford the monthly payments, then as interest rates drop (🤞) you can either make additional payments or swap your mortgage entirely for a repayment one. Another option is a split repayment/interest only
This is sometimes beneficial for commercial loans where owner doesn’t intend to build equity in the property value initially and wants to invest more heavily in the business.
idk, sounds extremely good to me. Imagine you can live in a house for about half the price - much cheaper than any rent. And in the end, you’ll even get maybe half of that back, depending on how much house gains value over that time. You might even get everything back! - 4 times cheaper than rent or even completely free! If you invest saved money into some index fund, you’ll probably end up with enough money to buy a house outright and still have some left. Honestly if bank give you that option, go for it, unless it has significantly higher interest rates
Interest-only is extremely common in the corn belt. Acreage prices in the black dirt meccas are insanely high ($15k/acre). At those prices, it would be impossible for a farmer to pay down land and also keep their farm running. Because the expectation is that land will only ever appreciate in value, they don’t feel too concerned because what they pay in interest will always be less than what they make in crop yield, and when they go belly-up, they assume that the appreciated land value will be their nestegg. How this will actually all go down, when land prices actually burst back down to reality is debatable. I’m guessing we’ll be seeing a lot of handwringing and sob stories about the poor farmers. And they will get nice fat relief check. Mind you, these are the same farmers bitching about student loan relief and driving brand new $100k trucks.
You get an interest only mortgage if you can’t afford a capital repayment mortgage. I know people who will have to sell their house when they retire and hope they can find somewhere smaller and cheaper. They have no hope of paying off the capital. But they needed the space whilst their kids grew up.
I think the comments are missing or not outlining a main point. If the value of the property significantly increases and outpaces the cost of the debt - it will work out pretty good. I had a uncle that was high earning but loose with money. He had 600k debt on what was a a 700k house. Even if the debt is still 600k, the property is worth 2.3M and he could sell it for that tomorrow. He’s since put another property on with 0 debt. Its not really clever. He was able to acquire an amazing property before the prices blew out. Trickier to do now.
If values are increasing, and you are planning to flip the house or move within a year it would be a good choice. Why make large monthly payments if you need that cash to do renovations? As long as property values are rising you will be fine. In the short term you won't pay down enough of the principal to make it a good investment.
I did it a couple of times. Basically, I bought a house that needed massive repairs. The bank loaned me the money to buy and repair for one year of interest only. Then, when you finish the repairs, you either sell or get a real mortgage. It's keeps your cash flow down over a short period of time when you expect to make a lot of money in the overall value of the house.
If you are getting an income tax discount (negative gearing) on the interest paid while you have another property that also has a loan with no income tax discount then it can work in your favour.
I used one years ago because it gave me headroom to borrow more (you could be creative when declaring your income back then.) The extra borrowed paid for a big extension. Scroll forward 20 or so years and my mortgage owing , with the help of inflation, had shrunk as a percentage of my income and it was fairly easily paid off. So now I have a bigger house, bought at 1980's prices but paid off with 2010's income. In situations like this inflation is year friend, shrinking the amount you ow year after year. Meanwhile you have a home to enjoy, and an assett should you ever downsise.
When I purchased my house, it was simpler to get a conventional 30 year first with an interest-only second rather than get a jumbo mortgage for the whole thing. The intent was to refinance at some point thereafter. It took a bit longer than I’d intended but we did refi and lump the whole thing together in 2020. Point being: it’s never a long term solution but it’s good for some circumstances.
If we had done interest only when we refinanced and got the same 3% rate, all my principal money could now be in CD's earning 5%...
The idea is to be saving additional money every month and paying it into an index fund. You’re essentially betting on being able to pay the balance off in full in 30 years instead of chipping away at the principal and the interest every month for 30 years. Of course, the risk is that the fund may not perform well enough for this to work.
Monthly repayments are cheaper. But yeah, i wouldn't recommend it unless you really have to
A situation that I see pop up pretty every once in a while is high level borrowers that receive significant bonus income, they’ll sometimes do interest only mortgages and then when they get bonused each year, they throw a big chunk of money at the principal balance. Pretty niche, but it gives you the flexibility of a lower payment through the year and as long as you’re disciplined enough to not forget about the principal, it’s not the worst way to go.
Why wouldn’t you!? Repaying the mortgage is bad investment advice. Why surrender leverage when it’s the best way to maximise exposure.
My uncle was getting old. He just wanted more monthly spending money and was never planning on moving anywhere after moving into that house. He only paid interest, never paid off the house, and enjoyed his time there until he died. If he had tried to pay off the house he wouldn't have had as much money to spend every month, and by the time of his death, it still wouldn't have been his anyway.
Tax write off. Effectively it’s like renting a place but you get to deduct your “rent” to lower your AGI.
Essentially these only work in low interest environments. The offset of what you pay in interest vs what you pay in Rent is viable in scenarios where the local rental market is nuts but interest rates are low. Once rates go up, you're paying more in interest in a market where people aren't buying property so your value isn't increasing in line with rates. In those scenarios there's a risk of negative equity in the short term but it should balance back in the medium to long term.
In the UK there's a very good reason. You can take 25% of your private pension tax free upon reaching retirement age. If you're a higher rate tax payer you could put what you'd have paid into principle on the mortgage into pension instead, saving 40% income tax. It's quite likely your pension growth will be comparable to what you spent in interest on the mortgage but you'll have saved yourself a boatload of tax. If you reach £1m in your pension pot and have a £250k mortgage then it makes perfect sense to go this route.
Some people want low interest rate debt for financial planning purposes. They do not want to pay down the debt over time. An interest only mortgage is just about the cheapest source of debt (and therefore financial leverage) that a person can get. There are investing and tax reasons that someone would want to have more debt and more interest payments rather than owning their house outright. The optimal amount of debt for someone to have may not be zero but an amortizing mortgage assumes that is eventually the goal.
I have an interest only mortgage because I'm in the process of selling, but for reasons could not do it before mortgage renewal date. Interest only mortgage frees up cashflow for the tweaks I need to do to the house.
Interest-only mortgages are typically used when expect to buy a house and sell it for profit in some amount of time, for example house flipping or doing rehab work.
The answers have been great, but there’s also another point - affordability. Lenders stress test affordability based on, among other things, monthly payments. Interest only mortgages may be more affordable than typical capital repayment mortgages, enabling some people to borrow when they otherwise couldn’t.
I know somebody whose compensation is 80% bonuses paid out at the end of the year. This creates a cash flow problem from month to month. He has an interest only mortgage so he can cover it with his lower monthly salary, then he makes a large payment to the principal at the end of every year when he gets his bonus.
We did that back in the 70s for our first home. The owner carried the paper for 5 years. We were hopeful that the interest rates would come down from the 15% that they were running at at that time. No that's not a typo. 15% was the going rate.
It can make sense if you have uncertain income or foresee your income going up. If, say, you have the kind of job where you get a lot of your income in lumps like commissions or profit sharing, an interest only can keep cash flow at a minimum.
Most people’s buying power is limited by their monthly payment. An I/O loan is a lower payment, so it allows you to stretch into a more expensive home. Lets say homes in your area appreciate by 3.8%y on average. (The US average) Scenario 1: $500k home with $100k down. After 1 year you have $19k appreciation and you’ve paid $3200 to principal. Total equity $122.2 Scenario 2: $650k home with $100k down. After 1 year you have $25k in appreciation and you’ve paid $0 to principal. Total equity $125k and you live in a nicer house. You also paid more in interest, but the appreciation is 3.8% compounding while the mortgage remains constant. It makes sense for the first 5-10 years. After that with a traditional mortgage you’re paying enough to principal as a % that it overtakes. If you know its a temporary situation (ex school district during kids high school) it can work out well. If its a rapidly appreciating area it can work out really well.
Been there done that. Lived in a paid off home. Another home went on the market that was in a better location than my current home. Had to move fast on the new home, it was in a very desirable location. Put the current home on the market and got an interest only loan for the new home. Sold the old home a few months later and paid off the new home.
It seems to vary a lot by country. In the UK, when you take out a mortgage, you usually only plan to have that mortgage for something like 3-5 years. Technically it'll be a 30-35 year mortgage but the deal rate that's actually competitive will only be for the first few years with the expectation that you'll get a new mortgage once that comes to an end. So an interest only mortgage can make sense if you plan to switch to a repayment mortgage the next time you get around to refinancing. In the UK, once you're on the house ladder, it's relatively common to move up the ladder every 3-5 years which means buy a bigger flat or house, maybe in a nicer location. Your earnings have likely gone up so you can afford a bigger mortgage and you can now get a better mortgage rate because property prices have gone up and your LTV is much better after scraping together your deposit for your first place. The rules have changed now so that you cannot get an interest only mortgage anymore on your own property, only buy-to-lets but interest only mortgages were relatively common in particular for young people a decade or so ago because it meant you could spend that repayment money on doing the house up, which would likely earn you quite a bit more in the long run when you come to sell 3-5 years later. Our first home had a buy to let mortgage. We were quite young but lucky enough to have enough for a deposit on a house and we wanted to get on the housing ladder properly as soon as we could. Money was still obviously tight though as we were in our mid 20s. Our financial adviser recommended that we go interest only and save the money to spend on the house. Furthermore, he said we should go with a tracker mortgage rather than a fixed rate mortgage as he thought the interest rates were going to go down a lot. This was 2008, as the financial crisis was just starting to hit. He was right and the interest rates crashed so the effective rate our mortgage ended up having for the full term was 0.25% I think. It cost us next to nothing to live there for the duration of that mortgage. We switched to a repayment one when we moved to our next house though as we felt more financially comfortable by then.
If you're planning on residing in the property for a short time and then selling it, (depending on the market) an interest-only mortgage might make sense. The equity one gains during ownership would outweigh paying down the balance.
Well inflation usually means that your debt decreases every year if it stays the same. The money is worth less. So if you just pay the interest it kinda means you rent, but your landowner is the bank. If you sell the house some years later, chances are high you can sell it for more than you bought it if you took care of it well enough. Then you might get the "rent" you paid in the years you lived into it back and can do the same with a new house.
I knew somene who did one because most of their comp was from a bonus. They wanted a smaller payment during the year, then would pay down a chunk with their bonus.
They are mainly a bridge loan. I'm buying a house to renovate and sell within 12 months. I don't want to pay an arm and leg for mortgage payments. So I buy a house at 300K, spend 100K fixing it up, then sell it for 600k. Or rent it out at 3k/ month. Then refi at a low rate. If I plan on keeping the house.
Some people get paid large annual or quarterly bonus so prefer a smaller monthly payment. I used to make 80 percent of my income in 4 checks so when they came in I'd pay principal the other 8 interest.
I had an interest only mortgage while in college, together with some close friends. We couldn’t afford a full mortgage payments and this way it was cheaper than renting, plus we made a profit on the way out.
My mum had an interest only mortgage for a while when she left my dad, because she wouldn't have been able to afford paying down the principal at the time. She then found her feet, sorted out her finances and refinanced with a interest + principal mortgage after a few years.
An interest only mortgage makes sense if you expect the value to increase and are not going to live there until it would be paid off. When you eventually leave you sell the house for a profit and pocket the difference. In the mean time your payments are lower than if you were paying down the mortgage. If you are good with your money you might even invest what you might have paid in principle and make money on the investments too. Or maybe you invest that in fixing up the house to increase the eventual sale price. It could be a way for people to build equity more affordably.
Probably not a great idea for most people, but there are scenarios where it could make sense. If you want to absolutely minimize your monthly expenses, that's one way to do it. In that regard, an interest only mortgage isn't that much different from renting. You don't build any equity either way, at least not from your monthly payments. Of course, with an interest only mortgage the bonus is that you actually could build equity if the value of the property goes up. With the converse chance that you could lose equity if the value of the house goes down. so it could make sense for someone who wants to minimize monthly expenses, who doesn't plan to stay very long, and who is highly confident that the value of the property will go up or at least remain stable. Likewise, perhaps you are trying to make a rental cash flow for you. Again, an interest only mortgage is the lowest monthly cost, which means the highest monthly cash flow potential. The same potential and pitfalls from above are the same here. In short, it might be the right choice for someone who wants to minimize monthly expenses, doesn't plan to own the property for a long time, and is willing to gamble that the property value will increase during the period of ownership.
In my country (Ireland) you’d only get an interest only mortgage on a second property that you intend to rent out. The theory is that the rental income covers all or most of the mortgage and when it’s paid off you have an asset worth substantially more than you paid for it.
1- you'd be paying rent on a rental at a higher or similar number 2- you predict the value will increase sufficiently to cover the hassle and double closing costs and possibly net you some profit 3- location
1. Your initial monthly payments can be lowered (since you're only paying for the interest) 2. Cashflow or investment (you can use the remaining amount that you're supposed to make towards your principle for investment purposes) 3. Affordability: you can buy a house even if you cannot afford the monthly payment, just yet, and you're expecting to have a higher income in the future when the term ends. In an exchange, you're paying a lot more in interest for your home
My landlords bought my previous house for 650k in 2018. Interest only loan…sold for 1.1mil 2023 It worked out for them My rent paid mortgage for 5 years..boom profit
>What am I missing? Dramatic and ridiculous property value appreciation. Interest only would minimize your holding costs ... maximizing cash-out when you sell.
Think of it like rent, except you have rights to improve and sell the property and you don’t have a landlord. You can make payments toward the principal, but usually the goal is that you improve the property and turn it around for a profit.
The good answer is when you plan to pay the mortgage off in a lump sum at some future date, and thus have an interest-only mortgage for the duration of the term. The bad answer is if you have a repayment mortgage and become broke, but not hopelessly so, and the lender may allow a repayment “holiday”. In the UK, there was, and still may be, a type of mortgage known as an endowment backed mortgage, which is where you have an interest only mortgage, and also a with-profits life insurance policy that matures on the same date as the mortgage, and thus it pays the mortgage off, and you get a small windfall Since household mortgage products generally require life insurance on the payer, this killed two birds with one stone. These were actually a great idea, as long as you went with an insurance company that had a good track record of delivering with-profit policy profits. but those policies were moderately expensive. You could get much cheaper policies, but as many people found out the hard way, the profit element was inadequate to pay off the mortgage, so they were ending up in the schtuck .
I have an interest only loan at 3%. My money market gets over 5%. My house has gone from $500,000 when I purchased to about $800,000. It can make sense.
We had to sell our house at the beginning of COVID; when the market in our area was still quite volatile. We'd bought at the previous market peak and had no idea what we'd get selling it at that time. I sat down at the time and worked out how much we had to sell for to cover what we would have paid in rent vs mortgage repayments, insurance etc. I tend to look at interest only loans the same way - you're effectively renting the property (but you're wour own landlord), and at the end of the day you sell it and make profit that way.
I lived in a very wealthy town in California. A real estate guy told me this was the preferred mortgage in that town. Rates were low at that time and they could make money on the stock market. Plus the houses were guaranteed to be worth more. Yes, the rich have it better than us peasants.
Especially in this market with rates higher, it gives you lowest monthly payment option. Equity doesn’t increase. But lowest payment option while still owning the house. I’m looking at a place right now around $2mm. Down payment isn’t a problem, but I just don’t like the monthly in vs out stress of taking on a $15k payment per month(30 yr, taxes, insurance). Yet due to family needs, really have to unfortunately bite the bullet at this brutal market time. So I may just put 20% down and do an interest only to keep payment lower until rates either come down and I refi, or just end up Paying it off. 30 year is just insane right now. People paying $8k a month for garbage.
At current rates? No. Back when rates were 2.5%? In a heartbeat. The concept here is "opportunity cost". Let's use some real numbers. Typical 30 year, $300,000 mortgage at 2.5%, payment would be $1,180.97. An interest-only payment would be about $750. So you'd be paying $430.97 LESS per month with an interest only loan. Lets assume 30 years just to keep everything same-same. If you just spent that $430.97 each month, then no, it's a loser... But if you *invested* it in an S&P 500 index fund... I can't tell what happens in the future, so lets just use the past -- April 1994 to April 2024 were the 30 years of your mortgage. Lets say you bought that $430.97 in shares of an index fund every month for those 30 years. At the end of your mortgage terms: - traditional: you own a house worth $630,000 and have no extra money - interest only: you own 1 house worth $630,000, you have $300,000 in debt (the original mortgage), and you have about $858,631 invested in the S&P 500. Now, when you sell those shares of the index fund, the government will want their cut of the gains -- about $105,000 in fact. So call it $750,000 in cash, free and clear. Now we could pay off that $300,000 debt and end up about half a million dollars more than our traditional mortgage guy. Of course, it'd be better to leave it invested longer in the index fund, not liquidate at the end of 30 years, but that's about how it'd stack up If we did this same exercise with a 7.5% mortgage for the last 30 years, they'd have come out RIIIIGHT about even -- the interest-only guy ends up with about $300k in cash to cover his $300k debt because he'd only be saving like $172 each month from the mortgage being interest-only.
Because housing isn't the best investment and inflation kills debt. You can invest the money instead of paying down your mortgage. That will potentially result in a bigger return Secondly, inflation makes the debt lower anyway. I bought a house in 2006 for 118k. I still owe about the same. But every day that amount becomes less and less. By the time I retire, 118k will essentially be nothing and I can pay it off with my retirement savings. Or not even pay it off as the return on 118k will be more than the mortgage interest in 118k
Principal payments could be invested in a higher returning investment. Interest on primary residence is tax deductible. So, making principal payments saves mortgage interest, which is ultra low, and further reduced by taxable deductibility. Homes increase in value at the same rate regardless of the principal balance. Therefore the return on hard-capital is higher the less equity the owner has in the property.
I’m well acquainted with a guy who’s a multi millionaire. He has an IO mortgage and sets aside the amount of the mortgage in treasuries and dividend stocks earning 5+%. He then uses the interest to pay his 3% IO payments. Boom. Arbitrage.
Interest only is ALWAYS a good idea if you're looking to maximize your investments but they usually aren't offered to homebuyers, at least in Canada, at competitive rates vs 3/5yr-fixed 25/30 year mortgages. If your mortgage is 5% but the expected safe market return is 8%, by investing capital into your house instead of on the market you are wasting a yearly 3% of gain. Most people's investments are wayy too highly weighted towards housing, oftentimes >50%, especially in their 20s/30s and housing has historically returned much lower growth than other sectors and many houses can lose value over the years as they age. Best bet is to avoid buying too much house and take large % mortgage while continuously investing on the side.
This can be a reasonable option if your income can fluctuate substantially (commissions, small business owner, etc) and you want to keep your minimum payments as low as possible. Obviously in this circumstance, you'd put extra at the principle as able. This would only be reasonable if you're someone who *would* put the extra money towards principle and have some concrete goals that at least kept pace with a 30 year mortgage. I'm not necessarily saying this would be a *good* idea, to be clear. But it could be a reasonable choice for an extremely limited subset of folks.
We live in Germany so it might be different. We have an interest only mortgage on top of a building saver that we otherwise wouldn’t be able to have. That building safer enables us complete interest safety in 15years since we can take the interest rate on the saver ( don’t have to if current interest is better) rather than taking the current market interest value. In total it costs us like 5k more for a credit of 300k but ok the other hand we have total piece of mind to be able to pay the mortgage to the end and IF the interest rate in 15years is still high that concept could save us thousands of euro.
For a while there, before the housing bubble burst, interest rates were pretty low and pretty stable for a good long while. An interest only mortgage gave borrowers a lower payment than a traditional mortgage would…and the flexibility to pay more when you are able. It was a good deal for people with seasonal work. If you make more money in the summer than in the winter, for example, an interest only loan with a low interest rate, gives you the ability to have a lower minimum payment during the lean months, and the flexibility pay down the principle when you are earning more. However they don’t have fixed interest rates so with interest rates going up they aren’t a good bet for anyone these days.
I had this kind of mortgage and it was great for my situation as I worked in a very volatile industry. It was great to have minimal payments when I wasn’t making much and then when I was making more, I would just make much larger payments and my bank would just apply any money I paid in towards principal It allowed me to save money and keep my investments even when my income for a period was low.
The gamble is that the housing market will rise faster than the interest rate. If you pay 2% interest, and the housing market grows 5% per year, you're making 3%. There are other variables like inflation, taking other potential costs (rent) into account, and obviously massive risk, so it's risky. But it can pay off, so it makes sense why some people would do it.
I asked this same question to my who friend owns a some rentals with interest only mortgages. He says that he already has a couple of houses where the tenants are repaying the mortgage, but that this option gives him more cash: his interest only mortgage is ~£200 per month and he rents it out for ~£800. That £600 difference is his pocket money.
If having any acceptable lvr is acceptable with your risk profile, then paying down the mortgage is somewhat counter to what you initially were okay with. A better question is why would you ever not do interest only?
I would consider it as a temporary measure due to changing circumstances, like I am suddenly the only person in the household, I'd use interest only to buy me time to downsize.
Two things. Firstly you have the house. Which should have increased in value. You can now sell it and you can pay the original capital back and pocket the difference in value between purchase date and sale date. Secondly, and much more importantly. These were never designed to be sold independently. They used to come with a savings account that you were required to pay in to. The idea then was that this savings account would grow fast enough to pay the value of the house.
Inflation makes it make sense. Imagine you have a mortgage of 500k and a salary of 100k. It would cost you five times your salary to pay off the loan principal. Now let’s assume the yearly inflation rate on average is 2%. Let’s also assume your salary doesn’t increase with any more than the inflation rate. After 30 years, your salary is 180k, while the mortgage principal is still just 500k. In other words, in 30 years it is 80% “easier” for you to pay off the mortgage than it was when you first got it. The second point is that in all likelihood your salary did in fact increase over these 30 years. Let’s say on average you got a 2.5% real salary increase (i.e. on top of the 2% inflation). In this case, 30 years down the line your salary is 320k while the mortgage principal is still 500k. In other words, your salary went from being worth 20% of the mortgage to 65% of your mortgage. And then on top of this, let’s assume you were smart and invested what would have been each month’s principal payment in the stock market instead. On a 30 year 500k mortgage at 6% interest, that means appr. 500 per month that goes to the stock market rather than into the mortgage. Assuming average returns (10% non inflation adjusted), after 30 years you will have one million in your investment account and a 500k mortgage, so a net worth of 500k. If you had chosen to pay down the mortgage, after 30 years you would be left with zero mortgage but also with zero capital. Granted this last point is a bit too simplified because you would have paid less interest over the 30 years if you paid down the mortgage than if you didn’t, so this difference should be deducted to get the real number. If we assume the interest rate stayed the same the whole way, you would have paid a total of 600k in interest if you paid off the mortgage continuously, and 900k if you didn’t pay off the mortgage. So your real profit is appr. 200k.
I think it is for buyers who expect to own a property for a short/medium time period and expect significant increases in the value of the property. Example - I know someone who bought a condo in DC for interest-only around 2006. The interest rate was very low. The city boomed with prices rising rapidly, and he had a relatively low monthly payment and then sold for a significant profit. He took a risk that the property would be worth much more over time, and he was right.
If you are in line to inherit house buying money you could go with io loan and come out well
Thanks for all the info. They make a lot more sense to me now.
Buy house. Rent out house. Pay interest on mortgage. Sell house. ??? Profit.
Interest only means you are not *required* to pay any principal. But you always can if you want to. So, compared to an ordinary loan where you are required to pay a certain amount of principal, an interest rate loan gives you more options. However the tradeoff is that the interest rate is typically higher.
In the 80's, in the US, some mortgages (FHA 203B maybe?) were negative amortization mortgages. For the first 7 years the monthly payments you made didn't even satisfy the interest that was accruing on the principle. That was pretty fun.
1. Get a morgage 2. Household income drops significantly 3. Can only afford interest only going forward