Are Interest Only Mortgages a Good Financing Option

Home prices have been soaring in Southern California, and many would-be buyers are exploring obscure financing options in order to enter the housing market. Today, we will briefly discuss an “interest-only mortgage,” (“IOM”) which allows you to pay only interest on your mortgage for a period of time, and then jumps up to include principal and interest.
Most IOMs are adjustable-rate mortgages (“variable-rate mortgage” or “ARM”). These loans start at a fixed-rate, generally lower than the rate you would get with a similar fixed-rate loan, but the rate increases after a set period. During that time, the borrower is only obligated to pay interest on their loans; of course, they are not building equity while they do this. That last sentence should give you pause, as you are essentially renting the property until you began paying down the principal on the loan. Of course, there are benefits as well.
Initially, your monthly payment will be very manageable – you are only required to pay interest on your loan ($3,000 per month on a $1.2M property at 4% for 5 years). Of course, once the period runs, you will be expected to pay back principal on top of an adjusted interest rate (in the example above, it could jump up to $6,000 per month at 5%).
Of course, before the beneficial period runs, you will have a significantly higher cash flow – if you are a savvy investor, this would allow you to build a nest-egg in anticipation of increased rates. Alternatively, you could spend that additional money improving your credit score, and attempt to leverage that credit score to refinance your loan to something more favorable.
On the other side of the coin, this beneficial loan option requires a 25% down payment, which would price a lot of people out of the current housing market. Additionally, and notwithstanding the point about credit score, these loans require credit scores that are above 740.
Moreover, you will likely spend significantly more money over the lifetime of the loan. This is partially because you only paid interest in the beginning, and because the interest rates themselves will be about 1.25% to 1.33% higher than a conventional 30-year fixed-rate mortgage.
Finally, during the interest-only period, you are not building equity in your home – you are essentially renting the property with an obligation to purchase it at an unfavorable rate later. Since you are not building equity, you will likely be out of pocket for any improvements you want to make on the home.
In short, it seems like an interest-only mortgage could be beneficial to purchasers who are seeking to flip their property in a hot market. It’s a gamble, but most investments carry risk with them. The question is whether you can afford to make that gamble.
At the Chernov Team we understand that knowledge is power, and knowledge of financing options is powerful knowledge indeed. At the Chernov Team we know that whoever comes to the table most prepared leaves with the most, and the Chernov Team always leaves the table with the most.