01Interest Only Mortgages - A Popular Choice During High Appreciation Periods
An interest only mortgage is when the borrower is only making interest payments on the loan for a set period of time, perhaps 5 - 10 years. At the end of that period, one of three things will happen:
- The borrower satisfies the principal with a balloon payment
- The loan is re-amortized and the borrower will have a new, significantly higher monthly payment
- The property is sold.
The advantage is that an interest only mortgage loan allows the borrower to defer principal payments for that 5 - 10 year period keeping monthly payments low, and potentially freeing cash for other investments, or to meet monthly expenses. Also, during this period, the interest only payments are tax deductible (consult your tax professional, please).
An Interest Only Mortgage / High Appreciation Period Example
The interest-only mortgage has become a popular choice for investors in areas in which rising property values, or high appreciation periods, have made finding positive-cashflow investments particularly difficult.
Here's an example, you are looking for a home. Real estate values and prices are rising in the area you're looking at. Simultaneously, your other investments are not doing very well. You might consider an interest only mortgage as the better strategy. But remember, lenders view interest only mortgages as riskier and they will price them higher.
Example: a 30-year interest only loan on $100,000 at an interest rate of 7.0%:
• Interest only payment: $583/month, $7,000/year
• Conventional payment: $665.30/month, $7,984/year
• Savings over the first ten years: $82/month, $984/year
02Life-of-Loan Charts and Reasons for an Interest Only Loan
Interest and Principal Payments
Figure 1, above, shows the monthly payment schedule for the loan. The investor pays interest only during the initial period of the loan, then the loan re-amortizes to pay the $100,000 principal balance over the remaining years.
Figure 2 shows that the principal balance remains flat during the interest-only period, and only begins to decline once the investor starts paying principal. An interest-only loan may be suitable for an investor who:
- Is trying to avoid negative cashflow in the early years of an investment,
- Plans to flip the property,
- Has other uses for the cash which would be paid as principal, or
- Is expecting high levels of property appreciation.
The primary risk to the investor is being left with negative equity if the market value of the property decreases, since no principal is paid during the interest-only period.
Other potential risks include:
- Your income has not increased as expected
- There may be prepayment penalties
- As many interest only mortgages are adjustable rate (ARMs) the initial payments may be low, but if interest rates rise, so will the payments
- You don't have the money when principal repayment is required
- The general real estate market declines and selling is not immediate.
- It is difficult to predict what interest rates will be if the principal is re-amortized.
The Author: Chris Smith is a real estate investor, founder of an online reference for investors and real estate professionals and has published articles in Corporate Finance Magazine, Euromoney, and the Business Journal Network.
03Update Since Mortgage Crash
I wanted to update this article post-crash. It's now 2016 and the housing market is still recovering from the crash that began in 2006. There was a lot of finger-pointing to place blame for the crash, and one of the targets was lax lending policies. Mortgage companies were blamed for lending to people who shouldn't have gotten a mortgage, or to those who got mortgages they couldn't afford.
I don't thing interest-only mortgages were a factor, as they're a pretty special niche used a lot by investors. However, some of them did go under because they were too highly leveraged. As with many creative loan types, the interest only loan became almost non-existent after the crash, but it's back in the mainstream these days. It does serve certain legitimate investment niche strategies well.