What type of mortgage?

October 4, 2005 8:16 PM

Interest only or fully-amortized mortgage? [much more inside]

I need help deciding on a mortgage. It's my first house, I'm 34 and single, and I plan to stay in this house for only 3-5 years. I currently pay $700 in rent in an apartment. The house is in University City, St. Louis, MO. I close on Dec. 1.

If I get an 5 year interest only mortgage (30 year adjustable, 5 year ARM, 80/10/10), my monthly payments will be about $1120 per month. If I get a fully amortized, monthly payments will be about $150 higher.

On one hand, the payments are already a little high for me, and I'm spending most of my savings to be able to put 10% down. There's no prepayment penalties on the interest only loans, so when I have the money available, I could send in extra money to help pay down the principal. I'm not great at living on a tight budget, so the interest only loan would give me the lowest payments AND the flexibility to pay more later if I'm able to.

On the other hand, I may not have the discipline to send in extra cash, which means that when I sell the house, I will have $12,000-15,000 less cash than I would have with a fully amortized loan. My goal in buying this house now is to use it as a starter home. I'm hoping the home will appreciate each year and I will have equity after resale to put towards a better house.

What do you all think I should do? Let me know if you need more information.

posted by kdern to work & money (10 answers total)

My knee-jerk, red-state take on this is that you buy a home because you'd prefer to build equity with your monthly payment (not because you're sinking your future into a speculative chance at appreciation).

For that reason, I'd reject the interest-only loan, on the basis that it doesn't function with respect to the above goal. Practical side effects of this decision include the fact that if, for whatever reason, you don't want to or can't sell in 5 years, you're not completely fucked and locked into a house where you have no equity.
posted by ikkyu2 at 8:26 PM on October 4, 2005

How much could you rent a house for? Because an interest only loan is not really going to get you anywhere that renting would not, except you'll have to put down a large down payment, pay closing costs, etc.

Do you realistically expect the house to increase in value? If not, you can basically expect to lose the closing costs on the loan (what, 3% or so of the house value) plus the costs when you sell the house (typically 6% unless you sell it yourself), so you're talking about losing tens of thousands over 3-5 years I'm guessing, in addition to the interest payments you'll make, $13,000 or so a year.

I really don't see the advantage of an interest free loan unless this is a lot less than you could rent a house for. In my personal case we lived in an apartment longer than we wanted to, and cut out EVERYTHING spending wise the last year digging up enough to make a good sized down payment, and in the process learned how to afford the difference between apartment living and the mortgage, taxes, etc (which actually was not as far from the apt. cost as it seems to be in your case)
posted by RustyBrooks at 8:26 PM on October 4, 2005

Do not get an interest-only loan. As noted above, if you decide to sell, you'll lose money on real estate commissions and other fees. In five years, when interest rates are higher, you'll be paying more because you won't have a cent of equity to help reduce the mortgage burden.

You might consider making balloon payments. Determine the fixed rate payment and the variable rate. Set the difference aside and use it to make balloon payments each month. However, keep in mind that you do bear the risk of interest rates rising. If you don't have a strong stomach, go with the fixed rate.

Also, consider putting down 5% instead of 10%. Buy something a little smaller or cheaper. Invest and remaining 5% and don't touch it. This is your emergency fund so that you can cover payments if you lose your job.

If you live in a college area, consider getting a place with a basement suite. Then you can use the rent to pay down your mortgage more.
posted by acoutu at 8:42 PM on October 4, 2005

In my personal view, interest-only borders on suicidal. If I were confronted with the choice between interest-only and not buying at all, I wouldn't buy. Then again, I'm fiscally conservative and tend to save huge portions of my income "just because."
posted by aramaic at 8:45 PM on October 4, 2005

Interest-only mortgages can make sense if you have the discipline to invest 1/360th of the principal every month. The nice thing about doing it this way is that in a conventional mortgage, your early payments are nearly all interest, but with an interest-only mortgage the payments are equalized, so you can put more toward the principal (i.e. into savings) each month from the beginning. You still bear the risk of falling (or even flat) home prices, of course, and rising interest rates, since you will either need to refinance or get stuck with the ARM after the first five years.

There are three scenarios in which it seems to me an interest-only mortgage might make a buttload of sense though:

1) You have enough cash to buy the house outright. In this case you take the interest-only mortgage and invest the money, and because the way taxation works you can come out way ahead -- you'll be able to deduct your mortgage interest at your marginal income tax rate, but will be taxed on your investment gains (assuming they're in mutual funds and not a savings account or something) at only the 20% capital gains rate. This strategy isn't without risk, of course, since they could raise the capital gains tax at any time...

2) It also can make sense if there's no penalty for paying down the principal. Quicken Loans offers a mortgage like this. The minimum you must pay each month is the interest on the remaining principal, but you are permitted to pay more (as much more as you want). Pay it as if it's a 30-year fixed mortgage (or 20 or 15) when you have the cashflow to do so. If you get laid off or have some other financial emergency, though, you can temporarily drop back to just paying the interest to ease your crisis finances, and make it up afterward. (But you'd better be disciplined, or every month will be an "emergency.") I imagine you'll pay a little extra in interest for this convenience, but it may let you sleep easier.

3) You fully intend to own the house for a decade or two, can get a long-term interest-only loan, have enough in the bank to make the payments for at least a year, and have your retirement all taken care of (including rent or a mortgage, which people who actually finish paying for their house won't have to worry about). In this case you may decide you'd rather have the money to spend now instead of paying off the house. Why not rent instead? Well, with a mortgage, your payment is basically locked in. If your interest-only payment is $750 and rent for a similar house is about the same in 2005, the $750 payment is going to look mighty good in 2020, after you've rolled it over three times, when the rent for an equivalent place is $1500. And, of course, the $750 remains tax-deductible; the $1500 won't be.
posted by kindall at 9:59 PM on October 4, 2005

There are certain types of people and certain types of situations where an interest only loan might make sense. Kindall's list is a good one. But this is a risky loan product that often gets pitched to people as a way for them to buy more house than they can really afford, and that is dangerous. I would say, based on your description of your situation, that you should probably get a traditional mortage, and a cheaper house too, if that's what it takes to get the payments where you need 'em to be.
posted by spilon at 11:05 PM on October 4, 2005

When my first three-year mortgage was up for renewal over a year ago, I decided to go with a line of credit set up with interest-only payments. This way I am able to sell whenever I wanted to and pay as much down as I can without being penalized.

I do make payments on the principal every single month. But then I'm disciplined. I have X amount of money budgeted for my mortgage, and my monthly payment = X - (interest charged me that month). There's no "when I feel like it" or "when I have extra money" about that monthly payment (though I do sometimes put extra money on my mortgage when I have it). If you can do it that way, go for it. Otherwise, lock yourself into a mortgage.
posted by orange swan at 5:20 AM on October 5, 2005

I would add a fourth scenario to Kendall's list -- you don't have much income now, but you expect to have more income or less expenses in the near future.

I recently re-financed and chose a 5/1 interest only ARM (rate fluctuates after 5 years). I chose this because my funds in the beginning would be limited (daycare costs and a single income), but in two years, I can start putting money towards the principle. I think interest rates will fluctuate within the next 5 years where I can re-finance again, and lock in a decent rate, no matter what kind of loan I get.

I feel safe that my equity in the house will continue to grow, simply because housing values will continue to rise, and that I'll be putting money towards the principle in a couple of years. I incur no penalties for when I make extra principle payments (I think this is the norm).

Also, since interest is tax-deductible, the equivalent of 30-35% of my interest payments count against my taxes owed at the end of the year.

Finally, I believe the bulk of the initial payments on a 30 year mortgage are for interest, so at the very least an interest only should give you a slightly better interest rate.

Also take a look at bankrate for advice.
posted by indigo4963 at 8:42 AM on October 5, 2005

NO INTEREST ONLY.*
I figured you're buying a $280,000 home. If you keep the home for 5 years and the value appreciates by 4% per year (a realistic assumptions), your house will be worth about $340,000 when you sell. After paying the sellers commission and other seller-side closing costs, you'll net about $25,000--that's the equity in your home and is just a little less than you put in for the down payment on this house. If you're feeling lucky, you can assume that your property value will grow by more than 4% a year, but betting should be saved for recreation, not residences.
*An interest only loan may work if you are in an occupation that periodically pays large bonuses. In this case, you should dedicate a portion of your bonus (equal to, say, 3% of the outstanding principle balance) to paying down the principle.
posted by GarageWine at 11:08 AM on October 5, 2005

Thank you all for your advice. As I am interested in building equity, and am not very disciplined at saving money, I got the amortized mortgage. Payments will be tough at first, but they will get easier as I earn more money in coming years.

It's nice to know I have MeFi to help with this kind of stuff!
posted by kdern at 12:19 PM on October 5, 2005