Against the grain: Why we chose an interest-only mortgage
Brian from Financial Dominance asked an interesting question on my post about our Zero Debt Goal. He asks:
Have you written a post about why you went with the interest only mortgage? My thought was that most of the personal finance bloggers advocate fixed mortgages pretty hardcore, but you took a different route. Also it looks like you put the mortgage together about 3 years ago when rates were at all time lows, so it would have made sense to slap a fixed rate on it.
Our Situation 3 Years Ago
I’ve mentioned before that we’ve increased our income by about 40% since 3 years ago mainly due to job changes. That means three years ago, we were making much less than we are now. Also, we had about $100,000 in debt at the time. You can probably see where this is going, but there’s a little more to the story.
We liked our apartment, but near the middle of our lease, we learned that our adjoining neighbor stole our mail (and about 100 others’), committed identity theft on another neighbor, hid an old Cadillac they said was stolen (insurance fraud), and had pretty hardcore drugs in the fridge. They were arrested, but it tarnished our opinion of the little community.
By the time all the drama unfolded, it was nearing the end of our lease term, and we also found out our rent was increasing by $200 per month. That settled it. We were going to buy our first home. Without getting into the details, we found our home, met with the broker and went through our options. Due to our debt, we didn’t have much room in our budget for a high mortgage.
Basically, we had the following options for housing:
- Renew our rent for about $1,700 per month
- Find somewhere else to rent and deal with this again in a year
- Buy a pretty nice, new condo in our town center (or near it)
- Buy a 20-30 year-old, moderate sized townhouse about 10 miles from town center
- Buy a 20-30 year-old, moderate-sized single family home about 20-30 miles from town center
- Buy a 63-year-old, small single family cape cod about 1 mile from town center
All of these homes were in the $300,000 – $400,000 range. We refused to buy a condo because we both grew up in homes with large yards. If we wanted an apartment, we would just rent one, not buy it. We checked out a number of townhouses, but they were all too small and not convenient to the interstate (we both worked in Virginia at the time). Lastly, we didn’t want to deal with the homes that were too far away because we knew the commute would be horrible.
So we chose our little cape cod that’s 2 miles from the interstate and smack-dab between 2 metro stations. We could never find anything so convenient to the metro and highway, with the plot size, square footage, and price anywhere in northern Virginia. So that’s why we bought in MD, but still worked in VA.
But why did we choose the “bad loan”? You can probably guess it was because the interest-only loan had the lowest monthly payment compared to a 30-year fixed loan. For another year after closing on the loan, we couldn’t really pay much extra towards our debts or savings until I made that first job change. Then we got enough extra each month to have some breathing room.
We didn’t do one of those crazy loans though, and we didn’t overextend ourselves either. We did a simple 5/1 ARM loan, of which we still have a little over 2 months to refinance. Also, we weren’t at the peak of the low rates 3 years ago. By that point, it was still a seller’s market, but not nearly like 6-12 months prior. The fed was already increasing rates, so we locked in at 5.25%. One other impetus for buying a home was the increasing rates. We got the market fever just like everyone else, but I think we made a very fine decision in our purchase.
Lastly, we got an interest-only loan because we figured we would only keep the house for 5 years and then move on (or away). We really do like our house, so that decision in 2 years will be a hard one.
So there you have it. The reason why we got an interest-only loan when the rest of the blogger community despises anything but a standard loan is because it was affordable. We just wanted some stability in location, which is why we got out of the rental market.
Looking back though, I often wish we had thought more about just dealing with the bump in rent and staying where we were. Owning a home is expensive, even with all the tax breaks. It’s an investment, but what many finance gurus don’t calculate is the time cost of owning vs renting. I spend a lot more time on this house than I ever did in my years of renting.
I would be interested in a comparison of the “working hours” spent with a home vs. renting. My wife and I have been going back and forth with whether or not we should buy a home, I think we should, but she would rather rent. Where we live, housing has dropped so low, and there are so many homes for sale that it is actually a cheaper mortgage payment on a house the same size as our apartment, than what we are paying in rent.
It looks like you had good reason to go with an interest-only loan, and you did a good job explaining why!
However, one thing you didn’t mention was your down payment. Did you make one?
I ask because my wife and I are in somewhat of a similar situation. We are currently renting but plan on having a child soon and would love to have a house within the next year or two. However, we have basically only started saving money a few months ago, after I finished graduate school (which was I able to do so debt free, luckily.
We live near Boston which also has houses in the 300,000-400,000 range. While I can afford a mortgage for a house of that cost, I have nothing close to the recommended $80,000 down payment. It sounds like, after having paid off your debt, you may have been in a similar situation?
Thanks.
Dang, you readers are demanding! I’ll try to put together something for your question Mark.
My wife and I were in a similar boat, 3-4 years ago. We decided to buy a 950 SQFT condo. I got into a buy down mortgage, because I didn’t know any better. Should have gone 30 yr fixed.
Unlike owning a house, buying a condo is significantly less work. It was a 7 year old condo so maintenance and even upgrades are few an far between. The association takes car of roofs, siding, stairs, shoveling snow, cutting grass, planting flowers, parking, policing neighbors.
The total actual costs(taxes, mortgage, maintenance) are only 200-300 more then renting. The cash flow has been a huge benefit, all our debt (except mortgage) is gone. Nice savings and emergency, and paid for cars.
With children now, we need a bigger place, but having a starter home worked out amazingly for us. We even have about $55,000 in equity.
I appreciate you putting this post together to answer my question.
This post certainly shows that there really is no “bad” loan. All loans have their place. The trouble comes when people who utilize these loans do not understand them and/or attempt to use them to purchase the maximum amount of house they can possibly afford.
Great post.
Brian’s comment (#5) summed up what I was going to say. You explained your reasons very well, and they are sound. I purchased a brand new car once and I still stand by that purchase to this day as what was best for me at the time. (I think I’ll write a post about it one day…)
I wouldn’t call Interest Only a “Bad” Loan. Just a dangerous one. Plus, most people who got into the Interest Only fad were doing just that,.. just paying the interest. Now they’re faced with selling their home for less than they bought it for and they still owe money on it because they were never working on building equity.
It’s still a viable option, if you know what you’re doing, but it’s just like a credit card… If you’re not smart about it, you’ll find yourself in a heap of trouble real quick.
Wow. I knew that you had serious debt but didn’t know that you also had an interest only mortgage. I’m sure you are in a position to make this work out for you, but seriously how did you plan to ever pay it off?
Plonkee, we didn’t plan to pay it off. We figured we wouldn’t be staying in the home for more than 5 years, so we figured we would put the extra “savings” towards our debt. It’s worked so far, but now we might end up staying in the house a bit longer, or we might not 🙂
Clever Dude (and all),
I also chose an interest only loan, for a few reasons – 1) More cash available to pay off higher interest debt, 2) It was the only option for my salary and the home prices in the area.
In addition to that, since I didn’t have a 20% down payment, I have a 2nd loan at a higher interest rate that I can pay off quicker with the extra money from the 1st.
I doubt I’ll be making 40% more in a few years, but thankfully my loan is fixed for 10 yrs, so I’ve got a little time to worry about refinancing.
Most people see interest only loans as a way to buy more house than they can afford (I’m somewhat guilty of this, but I didn’t include my wife’s salary on the loan application, so we’ll be fine). However, the one benefit nobody seems to mention is – one a dollar is in your house, it’s like a savings acct – doesn’t make any more money. All it does is reduce your interest amount. If you can invest that dollar somewhere else and make more than the interest deferral, it’s better to invest than pay off your house. E.g., if you have a loan at 5.25%, but you can make more than that in a long term investment, then invest!
Just my 2 cents…