Could you handle an interest-only loan?
It is an excellent option for some, but that depends on your needs.

How would you like a mortgage that either significantly lowered your monthly payment or allowed you to buy a lot more house? Sound too good to be true?

An interest-only mortgage can do either, and many buyers are finding them to be an answer to their prayers. However whether these loans are a blessing or not depends a lot on who’s doing the borrowing:

If you’re a disciplined investor, good with money, and not buying more house than you can handle, an interest-only mortgage could work for you. It’s also a perfect answer to someone who doesn’t plan on staying in their home more than a few years or is buying an investment property that they won’t own for a long period of time.

If you’re not any of those things, you probably want to stick to a more plain-vanilla mortgage.

“It’s a bad idea for someone who can barely afford the house they’re buying,” said Gray Buffington, President of Buffington Mortgage and an expert in helping real estate investors study the options of over 35 different loan options, including the investment-only: “If you’re using the extra money to put food on the table, it’s better to get a (more conventional) loan. However, if you only plan on staying in the home for a few years or are buying it as an investment property that you don’t plan on keeping long term, it is often an exceptional option in savings.”

The facts
Most mortgages require that you pay back some principal with each payment — a little bit at first, a lot more as time passes. Interest-only loans skip that requirement in the early years of the loan so that none of your payment goes toward paying down principal. The result is a significantly smaller initial payment compared with other options, such as a 30-year fixed-rate mortgage or a hybrid loan whose rate is fixed for the first five years:

How payments differ on a $500,000 mortgage
(Listed below as mortgage type, rate, and monthly payment):

Five-year interest-only
3.88%
$1,615

Five-year hybrid
3.75%
$2,316*

30-year fixed
5.75%
$2,918

* Assumes loan is amortized over 30 years, but rate is fixed only for the first five years.

Like regular mortgages, interest-only loans come in many different forms. The rate can adjust annually or be fixed for a while (usually five, seven or 10 years) before becoming variable. The interest-only portion may end after the fixed period, or it may continue for a few more years before principal payments are required. As with other adjustable-rate mortgages, there are typically caps that determine how much your interest rate can rise each year and during the life of the loan.

Here’s how it might work for a five-year, interest-only loan:

Your payments would be fixed for the first five years at a certain interest rate — say, 3.875%. (This is why, if you only plan on staying in the home for 5 years or less, that this is an ideal option.)

For the next five years, you still might pay just interest on the loan, but the rate would be variable and could increase by two percentage points every six months, up to a cap of 9.875%. If you invested the money you saved in the early years, many can still see savings at this time.

In the 11th year, if you remain in the home, the rate remains variable, but the loan requires you make both principal and interest payments.

Nobody can accurately predict future interest rates. But this is an example of what you might pay on a $500,000 mortgage if the rate started at 3.875% and jumped three percentage points in the sixth and eighth years:

How payments can change on an interest-only loan :
noted as:
Years
Rate
Monthly payment:

Years 1 to 5
3.88%
$1,615*

Years 6 to 8
6.88%
$2,864*

Years 8 to 10
9.88%
$4,114*

Years 10 to 30
9.88%
$4,783**

* Interest only **Includes amortization of principal over 20 years.

As you can see, the monthly cost climbs. However, if you only plan to keep the house a few years, a buyer winds up with far more home for the money than with other financing options which is why the loan has hit a great deal of popularity.

Not a long-term proposition, but a positive option for many.
Interest-only loans make the most sense when you’re borrowing a big chunk of money. At smaller loan amounts, the savings might not have as wide of benefit. An experienced and knowledgeable lender can help you explore if there are other loans more beneficial, however.

Gray Buffingon adds: “The typical time in a home is five to seven years” before the owner sells or refinances, “For someone who does end up staying in the home for 20 years, they might not like what they see in year 11 so we would recommend another loan option more beneficial to that client. The best bet for any client, regardless of what lender they choose, is to look for lenders with a wide variety of loan types, the experience to understand them fully, and a consultative lending approach to look into and advise what’s truly best so there is no uneasy hindsight in the future.” An easy explanation for Gray, as Buffington Mortgage offers over 35 loan options .

Gray also notes, for long-term ownership, that opting for an interest-only loan now means you’re passing up the chance to lock in today’s low interest rates in the future–one more reason it’s best as a short-term choice. If you wind up owning the home a long time — say 10 years or more — you may wish you had opted for that fixed-rate loan.

Interest-only loans were popular in the 1920s, when borrowers wanted to free up money for stock investments. The 1929 crash and subsequent foreclosures ended that particular party, but in the decades since then, private banks made interest-only loans available to their rich clients. These borrowers tended to have plenty of real estate exposure in other investments, were sophisticated about managing the risks and didn’t care about building up equity in their homes.

In the past few years, however, spiking real estate prices, mobile families, and real estate investors helped spark a revival for mass-marketed interest-only loans. Major lenders can offer programs like these where some lenders cannot. Interest-only loans currently make up about half of the adjustable-rate mortgages that some companies offer, or just under one in six loans the online lender makes overall.

Who chooses interest-only loans?
Interest-only borrowers, lenders say, come in two basic types:

The upwardly mobile. These people are stretching to buy more house, since the same payment on an interest-only mortgage will buy about 20% more house. Translated, that means someone who could qualify for a $500,000 house on a traditional 30-year fixed-rate mortgage might be able to land a $600,000 place with an interest-only loan. Many of these folks expect their incomes to rise sharply in a few years, and they want a bigger home now, rather than waiting to trade up.

The cash-flow crowd. Others want the smaller payment, for whatever reason. They could be investing the difference, or they might be business owners or commissioned salespeople with irregular incomes, said Washington Mutual executive Lenny McNeill. These borrowers want a smaller payment for the lean months, while being able to pay down their principal in big chunks when the money comes in.

Then again, a growing number of borrowers are content to let rising markets build their equity for them, McNeill said. They don’t want to tie up more money than they have to in their mortgages. They figure they can get a better return on their money investing it somewhere else.

“They’re more savvy, more experienced, more knowledgeable about finances,” said McNeill, head of Washington Mutual’s Southwest regional consumer group. “They more clearly see the benefits.”It’s a strategy that works very well while home prices soar, not so well when markets stall or tank. If you have to sell when prices are down and you haven’t built up sufficient equity, you could take a big loss.

But the ideal candidate? The buyer who will not own the home for more than a few years: this may be because they plan to grow their family and sell in a few years, because they are buying the property as an investment to sell, or because they want to remodel and “flip”…any reason that a short term purchase would be made. These investors tend to reap the largest rewards at the lowest risk.

For more information on Interest-Only loans or other loan options, contact Buffington Mortgage: 512-672-4729, gray@buffingtonmortgage.com