Interest-only mortgage payments sound like a good idea. As the title suggests, you’re paying only interest. This translates into having more available cash for other investments you might be interested in, like purchasing stocks and bonds. The concept, however, may be misleading because doing interest-only mortgage payments will not really free us from paying the principal amount of the loan at a later time.
The standard advice: tread carefully.
Your banker could clue you into the benefits to be gained. But like most financial products, there are risks. Some experts think that interest-only mortgage payments are no more advantageous than say a traditional mortgage. Much depends on your liquidity position (how much cash you have and your net worth), the payment schedules, and your money management skills.
Nature of Interest-Only Mortgage Payments
What may look like a benefit at first glance could become a disadvantage at some point during the life of the loan. In regular or traditional mortgages, payments for the first few years usually take up a substantial portion of every dollar that goes into paying interest. If you’re paying say $800.00 every month for a traditional mortgage, about $700.00 goes into interest while $200.00 goes to paying off the principal. By doing interest-only mortgage payments, you save $200.00 by paying only interest.
Does the $200.00 – at least for the first years – represent a real benefit to you? One thing is sure: not paying principal today could mean paying more interest tomorrow.
Once upon a time, interest-only mortgage payments were created and packaged by lending institutions for preferred clients – well-heeled individuals who had savvy investment knowledge and who could channel payments intended for the principal loan into other investing opportunities, like purchasing a particular stock that analysts will think will triple in value in the next six months. By using the cash to purchase stock, investors place their funds into additional revenue-generating sources. When they end up with a windfall from their stock investments, they cash in at the appropriate time and make a large payment on their mortgage during the anniversary period. What they’re doing is delaying mortgage payments so they can make a handsome profit in the stock in a short period of time, leveraging their cash portfolio to build their asset base.
Sounds like solid money sense, doesn’t it? Absolutely.
But let’s take the other side of the coin. We’re assuming here that the investor timed the stock market accurately. He maneuvered very well and executed on his investment strategy effortlessly. But what if the company went belly up and the stock turned into a junk stock? The outcome looks bleak: he’s got not only the unpaid mortgage principal but is also in the hole thousands of dollars because the stock is plonk (cheap wine).
Like we said, tread carefully.
Smart investors will resort to interest-only mortgage payments if they’re confident that their investments will produce a win-win situation and if they have sufficient resources to weather a temporary downturn.
It used to be that interest-only mortgage payments were available only to sophisticated investors. Today, it’s common currency, and many people prefer to go this route with their banker’s blessings.
Never Say Never
One essential point to remember is that interest-only mortgage payments don’t last forever, even if tied to a fixed rate mortgage. Some banks will allow interest-only mortgage payments for a certain number of years – maybe as long as one half of the total term of the mortgage, but policies vary from one bank to another. Clarify this particular issue to avoid any surprises when you receive your mortgage statements.
Interest-only mortgage payments were geared towards cash flow or alternative investments, but this has changed. When the housing boom occurred, potential homeowners swarmed into the market, pushing demand for housing to new highs. That demand translated into a sellers’ market and people with modest resources could not purchase property because of their income.
What happened next?
Lenders saw the situation as an opportunity to lend money, putting properties within the reach of millions who didn’t have the necessary cash for a down payment but who wanted in anyway. Lenders therefore began offering products like interest-only mortgage payment options so that they could expand their client base and enable more people to jump into the affordability paradigm.
If the home buyer has sufficient resources, there’s usually no problem. But when a potential buyer doesn’t have the minimum down payment required and also avails of interest-only payments, then what that home buyer is doing is buying more debt. He falls into the class of debt-leveragers – a phrase to describe impulsive debt-hungry souls.
Interest-Only Payments: Risks
Leveraging is both a science and art. It’s also what we like to call a killer instinct. It can yield dazzling sums of money, thanks to an investor’s acumen and money skills. For someone less sophisticated, leveraging could be risky. House buyers who use debt leverage –an example of which is doing interest-only mortgage payments – fall into the temptation of buying an expensive home with a large mortgage, believe that their incomes will be there forever, and also gamble on the notion that their house will appreciate in value. This is where the red flag comes up: because they’re paying only interest and not the principal, they’re not building equity. Equity, to them, will be an elusive goal. What if the market fails to meet their expectations because the home market does not appreciate considerably as originally thought?
The risk in interest-only mortgage payments is that by not paying the principal down, the homeowner has no equity to build upon for his retirement years and is hoping that the market will go on an upward trend. Hocus-pocus. Even if the gurus say that real estate is a solid investment, we mortals just have one house (some may have two or three) in one neighborhood and in one town. How does one measure the “profit spread?”
Besides, required down payments are falling. Up until a decade or two ago, the Canadian market required a 20% down payment on mortgages. Today you can purchase a home with only 5% down. In the US, typical down payments went from 10% in 1990 to about 3% in 1999, encouraging more borrowers to come forward.
What possible outcome can one expect from interest-only payments? If the house does not appreciate in value or if the home buyer gets downsized in his company or falls into hard times, he could be selling his house at much less than what he signed for it.
Here’s another risk: what if interest rates rise and the interest-only payment method is tied to a variable or adjustable rate? How long can the borrower stay afloat in this kind of situation? Will he have any money left to pay down the principal? You may argue that we’re at all time low in terms of interest rates and it looks like it’s going to stay that way for some time. Fine. But what has history taught us about low interest rates? They’ve got to go up sometime.
To illustrate: your interest-only payments are $800.00 a month, and you’ve chosen an open adjustable rate type of mortgage. Prime goes up. Instead of paying 5.1% interest, you’re now paying 6.1%. That’s a full percentage point. Your $800.00 interest-only payments will logically rise.
Interest-only Payments: Not all Bad News
Despite the risks, you need not turn your back to interest-only payments. They’re the ideal arrangement for individuals who like to invest smartly but prudently and are able to sniff and spot good deals in other types of investments. Interest-only payments can be very practical for borrowers who manage their funds well and who want to accumulate assets, not more debt.
Another advantage is that instead of paying off the principal immediately, one could actually use the cash to renovate the house or add improvements to it. By doing so, the house value increases. By saving $200.00 of the $800.00 monthly, that $200.00 over a 12-month period becomes $2,400.00 which could be used to partially renovate a basement, buy new kitchen cabinets, or change the door knobs – anything to make the property more attractive should the time come to sell it.
Money for retirement or money for education – you choose. By doing interest-only payments, you can grow a cash reserve to fund your retirement dreams or send a kid to school.
And…we all know that sending a kid school is one of the best investments you can make in life!