Using an Interest-Only Mortgage is a Recipe for Disaster for Most People

Here's some great advice from the book The Automatic Millionaire Homeowner by David Bach (FYI, I reviewed the book and liked it a lot -- 7 stars) on the significant downsides to interest-only mortgages in the vast number of cases:

Interest-only mortgages make sense if you're planning to own the home for a relatively short period of time (say, less than five years) and have a good use for the money you'll save. But using one simply to buy a bigger house than you can really afford is a recipe for disaster.

Question: Why do most people use interest-only mortgages?

Answer: To buy a bigger house than they can really afford.

That's why I hate these mortgages so much! They lock people into a large amount of debt that they make no progress on.

Again, that's why I have a very specific formula I recommend for buying a house. I suggest you consider it if you're thinking of buying a house.

Comments

[jayfer]

My older brother has an interest only loan, and he used it to buy a tiny 3 bedroom condo in the Bay Area. And no, it probably wasn't a wise idea. But housing is so expensive in that area that it's next to impossible for regular folks to afford even a tiny place.

By the way, reading the moneyblognetwork blogs over the past few weeks has inspired me to create a blog as well.

http://inchoaterandomabstractions.blogspot.com/

Thanks!

[Lee]

Interest-only and 100% mortgages can be used for evil, but they can also be used for good, IF you are financially savvy AND disciplined. Leverage can be a beautiful thing. I have an 80/20 interest-only loan. Before I bought the house, I calculated the max I wanted to spend on housing (25% of gross), figured out what regular mortgage I could comfortably afford below this figure, then took out the IO version of the loan. The 80/20 option allowed me to avoid $100+ in PMI every month. It also freed up cash for other investments. With rebates, seller incentives, and carefully vetted closing costs, I bought my house with a total investment of $335.00. I always pay what the full P+I payment should be plus an extra 10%. In 9-months, my house's value has increased $40,000. Even if I had to pay a realtor to sell tomorrow, my gain would be close to 90%. Leverage is a great tool. You just have to make sure you don't get too greedy. Banks approved me for 100K more than I was willing to spend. The problem is not will IO loans, but what people do with them.

[Matt]

I put 10 percent down and financed the rest with an 80/20 primary/second mortgage combo on my house to avoid PMI. In 10 months (this month), my house appreciated and appraised at nearly $100,000. We don't want to move, but we did get a home equity loan at a low interest rate in order to pay off the second mortgage, credit cards and vehicles with higher interest rates. This seemed like a good idea...was it?

[David Porter]

FMF,

The mortgage industry has changed significantly in the past 10 years. One of the biggest changes is the number of "niche" products now available.

The "interest only" mortgage has recieved a lot of attention because people are using it to buy more house than they can really afford.

However, just like options trading isn't for everyone lets not through the baby out with the bath water.

The interest only loan is many times the perfect solution for late baby bommers for example who need to catch up in their retirement savings. If the interest only loan can re-allocate $500/month into savings for them, it is many times the solution for their life of spend, spend, spend.

Keep up the good work. I enjoy your blog.

[in need]

My wife and I are close to buying our first home. We are in our mid 30's and got a late start in life ( we traveled and never wanted to stop). We have decent jobs. No car payments, 600 a month student loan that we recently refinanced. Our duel income is about 180,000 a year. We are not looking to buy for investment purposes only. Ideally we find a place to call home and can get old there. With this being the case, we thought if we get a 10yr. interest only loan we would be able to get a little more house while being able to dictate what we put towards our principle.

Would anyone recommend this tactic? Is a smart 30 a better option?

[FMF]

Personally, I wouldn't go the interest-only route, especially if it's because you're trying to buy a house you really can't afford, but I'm sure others would disagree.

[Tan]

In 2004 we put about 30% down for a $825,000 home and took out a $592,000 interest only loan at 5.86% fixed for 7 years. We have been paying extra each month towards our principle. So far we have managed to reduce it to $470,000. We have a $100,000 emergency fund that earn between 5.4%-5.7% in CDs. Hopefully, by June, 2011 when the fixed rate is up, we could reduce our principle to $170,000 with less money in the emergency fund. We then can refinance or pay it off within a little over 3 years. I don't think the interest only loan is that bad for people with high incomes and with good discipline. By the way we also maximize our 403b and 457b accounts as well as roth IRAs.

[Hoff]

Interest only gives the consumer more cash to spend which helps the economy, or more cash to pay off debt each month. Think of it as renting your own huse to yourself and the principal never goes down unless you make those extra principal payments. Great for those who feel confident the property value will increase. I am going to do one this time around for a refinance, as long as you stay on top of the closing/broker fees, they are a good thing and only agree to no or 1 year prepayment penalty!!!