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Interest Only Loans Buy 20 Percent More Homes With Maximum Interest Deductibility

Feb 10, 2008
A lot of the press today is states that interest only loans are "bad" and that they should be avoided. Instead, let's examine why you might want to get an interest only loan. Once you understand how the typical product works, you can make your own educated decision. Think of your mortgage as a financial instrument that needs to be managed and integrated with your other financial goals.

A conservative example of an interest only mortgage product allows for ten years of "interest only payments". The repayment period of the loan is traditionally 30 years. The interest rate is fixed during the entire 30 year repayment period. This loan offered through lenders selling to Fannie Mae. Fannie Mae is a government sponsored entity. They are very large and significant purchaser of loans, so you shouldn't have too much trouble finding this loan. Most mortgage brokers will be able to offer it to you.

This loan product allows the first ten of the thirty years to have payments based on just repayment of the interest or "interest only". After the initial ten year period, the outstanding remaining balance, often the same as it was in the beginning, needs to be amortized and paid off. You now have a 20 year loan, which represents the remaining time left on the mortgage. The interest rate remains the same as the initial rate. There was NO change in the interest rate. There is no interest rate risk. The only variable that changes is the amortization period, having gone from 30 to now 20 years. If you want interest only payments again, simply refinance. In fact, there are no prepayment penalties to pay off this loan.

How can an interest only mortgage be a good thing? Your mortgage payments are less than a traditional amortizing loan. The actual payment differential is about $100 per 100K borrowed. This means you can get the home you want for a lower payment. This allows you to allocate the "savings in payments" into other places. One good place might be your retirement plan. For example, maybe you are not taking advantage of a retirement plan at work or the employer match. Salary deferred into a retirement plan is generally on a pre-tax basis. This allows you to pick up the differential in dollars that would have been lost to taxes. Instead these tax deferred dollars are compounding in your retirement plan. If you are able to pick up the employer match where you hadn't before, you effectively are earning up to 100% on your deferred dollar, assuming the match is dollar for dollar.

Interest only payments enable you to buy a larger home with the payment you find comfortable. This generally translates into 20% more of a home for the same monthly payment. This extra 20% of buying power might allow you to "buy up" to what you really want. Getting more of what you need in a home will allow you to remain in that home longer and build more equity. Moving often may strip you of a lot of your potential equity due to the costs involved in buying and selling a home.

You can't deduct principal. At the end of the year, your lender will send you a 1098. This form represents the amount of interest that you've paid in the previous year. This is what you may be able to deduct on your taxes. Principal repayment is never deductible and may actually accelerate the loss of your "tax deduction i.e. mortgage interest" by reducing the outstanding mortgage balance from which interest is calculated.

You may be able to earn a higher rate on your invested funds than the rate you are able to borrow money at for a mortgage. This is mortgage interest rate arbitrage. This is why you might want to borrow as large a mortgage as you feel comfortable maintaining and invest your equity somewhere else. Following this strategy, you are doing the same things that banks and insurance companies participate in. Last time I looked, it worked pretty well for them.

Your equity due to appreciation grows the same way regardless of how you finance a home. Equity growth is based on the appreciation of the underlying property. Consider this: if you can buy more of a home with an interest only loan, and if all homes appreciate by the same percentage, then you will gain more equity from the home that initially costs more. The equity that you are building through amortization by paying down on a mortgage is really just a "forced" savings plan. It may be possible to take these payment savings that you pay into the "forced" savings plan and instead invest them into some alternative investment that will appreciate at a higher rate. If you should want your home paid off or paid down in the future, simply liquidate this alternative investment and apply it to your outstanding mortgage balance.

What are the negatives? You might be able to argue the other side of the advantages I've outlined, but I think you would be remiss. For example, you could argue that there are no alternative investments that offer a higher rate than the net rate you're paying on your mortgage based on the risk you are willing to take. This might be the case for the most conservative. If that's the case, I still think the other advantages provide enough reasons to consider an interest only loan. To be objective there might be one risk to consider. If you don't think you can make the mortgage payment after the interest only period and you feel that in the future you might not be able to refinance or sell your home, for whatever reason, then you should stick with a traditional 30 year fixed conventional loan.
About the Author
Minnesota Mortgage Broker-Venture Development 952-285-4319 MN mortgage broker at my website at http://www.ventureloanapp.com John Mazzara sells Minnesota real estate in the Twin Cities(Minneapolis/St Paul), MN with RE/MAX 952-887-1290 MN real estate at my website at http://www.selling.mn We offer mortgage loans programs for First time buyers, investment property, refinancing & consolidation of debt
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