Interest Only Loans - Good or Evil?
I used to think Interest Only loans were the worst possible way to finance a property. You are really in essence renting from the bank instead of a landlord. Why would you do it??
The first time I saw Interest Only Loans used was when I went to California to visit a friend. He was telling me that everyday people couldn't afford to purchase a property with a conventional loan let alone a low-interest loan, so many people were resorting to Interest Only Loans.
I thought this was crazy.
I was pretty shocked by how this was totally upside-down from our area in Greensboro, NC.
Now of course in GBoro, the economy is not that of California. Properties aren't increasing by double digits, but at least they haven't been stagnant either.
Either way, I was watching TV this weekend and saw an ad for an Interest Only loans for our area.
With a new property foreclosure we are about to purchase, I was wondering how I could our company could use a Interest Only Loan to our advantage. Here is what I came up with:
When you pay a normal loan, the Interest that you pay is huge compared to the principle that you pay. But by the 10th year of your amortization, you are contributing a larger portion to Principle than Interest.
Don't let me lose you now. If your using an Interest Only Loan that cuts your monthly payment down by 40%, then that means if you pay what your normal payment would be, your principle contribution would be significantly higher than what a conventional amortization would be. Much Larger!
If your monthly payment is 1000/m and the IO loan brings your payment down to 600/m. This means if you normally pay the 1000 per month even though your normal payment is 600. You are really knocking down your principle.
It is just like coming in on a 30-year loan at the 7-10 year mark.
WHAT DOES THIS MEAN FOR YOU?
It means that for the first couple years, you can really knock down your principle faster than a conventional mortgage. Then after 2-3 years, refinance to a conventional 15 year mortgage.
Now these are ONLY thoughts I had this weekend while reflecting on my refinance. I haven't verified that the Interest-Only Lenders don't have a pre-payment penalty. But I would assume that they would have one in place to protect themselves from guys like me who don't want to be screwed when it comes to paying my debt off.
What are you thoughts?
I don’t know that this is figured correctly-
For example- If your take a mortgage out for $150,000 at 7%, your a fully amortized payment would be about $998- If you had this same loan with an interest-only option, your payment would be $875. This isn’t a 40% difference. You’re lowering your monthly payment by $123.
Let look at what happens if you pay this for 3 years both ways.
If you pay the I/O payment of $875 for 36 months, your total payments would be $31500 and your principle balance would remain at $150,000.
If you set this up as an I/O and pay $998 a month, you are more or less paying down your principle by $123 a month- So after 36 months, you would have a principle balance of $145,572.
Now if you set this up as a fully amortizing mortgage paying $998, because the amount of interest each month is amortizing, after 36 months, you would have a principle balance of $145090. Using this type of loan will actually pay down your principle balance faster than using an interest only loan and paying the fully amortized payment.
You also must keep in mind that when you opt for an interest only loan, more than likely the lender will put a “bump" on your rate. You don’t have to worry about Prepayment Penalties with I/O. There are several loan programs available that do not have a PPP.
Having an interest only loan isn’t like renting from a bank. In the right market, you will experience appreciation while keeping your cash flow more positive.
For any question on investment financing please don't hesistate to contact me.
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How did you figure the Interest?
From the commercial that was advertised "Quicken Loans" they say a 30-40% savings.
The point of the articles is that for a brief period, going with an Interest Only Loan to start off with and then switching to a conventional loan at a later time, be it 2 years down the road or 5 years down the road, it might be a great way to save interest.
Thanks for the numbers, BTW.
The way that they get such low payments is with a negative amortization loan.
For a very good amorzation table check out <!-- BBCode auto-link start --><a href="http://vertex42.com/ExcelTemplates/excel-amortization-spreadsheet.html" target='_blank'>http://vertex42.com/ExcelTemplates/excel-amortization-spreadsheet.html</a><!-- BBCode auto-link end --> dowloand the one "Loan Payment Schedule (with optional extra payments)".
To calculate your interest only payment you multiply your loan amount by the interest rate and then divide by 12.
($150,000 x .07) = 10,500 / 12 = $875
I wouldn't reccommend your strategy for two reasons: 1. your not saving any money and 2. if you change your mortgage after a couple of years you will incur a couple thousand dollars in closing costs.
Right. But for them to advertise 30-40, they must be giving out a really great interest rate.
Yes closing cost would still be 1500 bucks, but on a high priced property, that could make the difference.
Equity in your property has no rate of return. I do not think there is any problem with interest only loans so long as you are investing the difference in payments not making an SUV or boat payment instead. If you are pulling out equity in your property and paying 7% annual but earning even 5-6% compound (like with real estate), the numbers are easy to determine. Now, most of you think that the best way to own a property is to own it outright with no mortgage, I disagree. Would you bury $100,000 or more in your backyard to earn no interest? That is what you are doing with leaving equity trapped in your house(s). A great book that details this more eloquently than I ever could is "Missed Fortunes" or "Missed Fortunes 101" by Douglas Andrew, highly reccomend reading that.
Ray the only problem I have with keeping properties highly leveraged is the thought of beginner investors that don't have enough cash to purchase the property to begin with.
This can cause a really bad scenario where the morgagor can risk foreclosure if a bad market comes around.
In the GBoro area, that happened to us over the past 3 years and we were highly leveraged.
Now that we have some equity, I don't think I am going to risk taking out a second mortgage to play around in the stock market.
I agree with new investors and veing wary but a bank will foreclose on a property with a lot of equity faster than one that is highly leveraged.
Agreed with the 2nd poster- this original thread was figured incorrectly. The benefit of the I/O loan is as the other poster stated regarding using the extra cash flow for additional investments - not money savings.
Also - consider that by paying down your principle you reduce the amount of interest you can deduct against your rental income, more and more each year, until 1 day, it will not exist at all! I prefer to keep the deduction and not pay tax on the rental income, especially when my renters are covering my interest payments for me, and I'll take the free appreciation in return.
Why in the world would you want to pay a constant debt just to get a tax break?
You could get the same tax break by donating the money to charity, then paying your taxes.
It is true depreciation is a great asset to holding real estate, but I wouldn't soley take out the money just for the tax deduction. I would do it to use the leverage on another project.
Hmmm. Never thought of that. Good Point.