Can you please explain simply why an interest only loan is a bad idea?

Question

We plan on getting a conventional loan, but have come to a road block. The PMI, with our poor credit score, makes our monthly payments $200 more than we can afford. We paid off a debt, at the advice of our loan officer, but ran into a problem. (see my other question). Anyway, if we can't get our credit score up in the next week, we can either accept the payment that we can't afford or an interest only loan. I have heard a million times not to take an interest only loan, but can't find the reasons. We are first time home buyers, plan to live in this house for 5 years or so, and need simple and clear info about this. Thanks.

Answer 1

Very simple scenario to explain why NOT AN INTEREST ONLY LOAN.

You take a 5 year IO loan for 200k. In 5 years your IO expires, you know start paying back that 200k AND it will be adjusted to the current rates (could be higher). Your payment will more likely to be more that what your were paying interest only. Is your earning potential going to change in 5 years? If not, I suggest not taking the IO loan. These loans were originally designed for investors that dont plan to live in the home or for people that knew they would be getting substantial raises in the next 5-10 years to come (DRs, lawyers, etc). Bottom line: DONT GET AN IO LOAN.

Answer 2

B/c all you are paying off is the interest, not the principle. Say you borrow $1000 and only pay off the interest for one year, you still owe $1000 after that one year.

So if you buy a house using an interest-only loan, you'll still owe all the principle after that 5 years, plus all that fees associated with the closing. What's the point of owning the house then? Why don't you just rent instead? Say the house is worth $100,000, and your effective interest rate is 8%, you are paying $8000 a year on that house. Plus you have to pay the property tax and any repairs. You will only benefit if the house goes up in value. What if it doesn't? Five years isn't a long time for a house to appreciate. (What we saw in the last 5 years doesn't happen all that often.) If the house is worth less when you sell, you actually have to pay the difference.

I advise you not to buy a house until you have a better credit score, plus you have the money to afford a traditional loan (at least a 5-year ARM.) The cost of owning a house is not just the mortgage itself, you also have to pay the property tax, repairs, furniture, probably bigger utility bills than renting, and much more. A lot of people don't realize this, and get a bigger house than they can afford. Now that the housing market is in a slum, they end up with a house that is worth less than what they purchased it for.

Answer 3

YOU WANT INTEREST ONLY.

First off, less than 5% of people pay off their home.

Secondly, if you are only going to be there for five years, why pay principal. why not put your extra payments (to principal)in the bank. It will give you more money. Also, in five years you will pay very little to principal anyway.

Third, your loan officer is giving you the wrong loan. With poor credit, the right lenders dont charge PMI. or if you do have good enough credit, get a first and second mortgage. it will cost less. PMI is money that goes to nothing. It is just loss mitigation for the lender.

Pull out a pen and paper and do the math, anyone who does this will understand that a P&I loan doesnt make sense unless it is the last loan you will ever have. Why not have the option of a lower payment and if you have extra and want to, put it towards the principal.

Answer 4

I would have to agree with the explination from my counterpart Sarge. When it's interest only, that is what you are paying...Interest only. You are not doing anything to your principal balance. For a home that you intend to occupy and live in for a while, I DO NOT recommend it. IO is great for investment properties in areas where the property values are increasing and you plan on selling the home for a profit in a few years. It gives the lowest payment and then 4 or 5 years later when the house is worth more than what you bought it for, you sell it for a profit while gaining rent profit since your payment is so low.

If you are going to live in the house for a while, the only way you can make it work to your advantage is to make additional payments to principal each month, but most IO programs will only allow you to do so much of that, while others won't let you do it at all. I wouldn't suggest that because that is almost the same as getting into a payment you can't afford.

Answer 5

If you live in an area where property values are increasing and are projected to do so, an interest only loan may (and I repeat"may") be a viable option for you.

Problems arise when borrowers accept these types of loan merely in order to qualify, property values decrease, the borrowers run into payment difficulties and then find they cannot sell the home for an amount sufficient to payoff the loan.

These are, generally speaking, not the best choice for first time buyers. You would be better off finding a home that is less expensive, staying in it for that 5 years and then using your equity to buy up. That way you will have the experience of being a homeowner and understand all of the additional expense involved above and beyond the house payment and, hopefully, have funds from the sale of the first property to buy the home you really want.

Answer 6

An interest only loan is not a bad loan or idea. It is only a bad idea when you fail to realize why you got the interest only loan in the first place.

The other thing is don't forget that this loan is for a period of five years only.

Now during this five year period you must correct your credit and get your scores up, so you can now refinance into another loan preferable a fixed rate product.

Now this is why the five year loan is a bad idea. You will not work and bring your credit scores up. At the end of five years if you are in the same position you are in now you will be blaming everyone except yourself for getting into this loan.

So my advice to you is take care of your credit, get the credit scores up, don't buy any cars or furniture that you can not afford.

At the end of the five year period you will be in a position to refinance into a new loan.

I hope you will find this of some use to you, good luck.

"FIGHT ON"

Answer 7

Interest only is not a bad loan....Basically the first 10 years you will be paying pretty much paying intrest anyway on a regualr conventioanl loan..for ez...if your mortgage paymant is 1,000 a month regular 30 year fixed. About 900 of that payment is going to interest anyway . So you are better of going interest only and saving that extra 100 towards bills or whatever other bills. You should also have reserves just in case .When owning a house it can get exspensive. Plumbing problems, roof problems, etc. If you cant afford the payment I would advise to go with a lesser house then so you are not stressed out if something happens.

Answer 8

Because with an interest only loan, you are never going to own the property. You will build equity through price-inflation, but you cannot pay off the principal of the loan.

There are situations where it can make sense though - for an investment property for example, where the interest is a useful right-off; or if you plan to sell the property in one or two years, where with a traditional loan you wouldn't have paid much off the principal anyway. Five years is a stretch, but given the rest of your question, I'd suggest going with the interest only loan. Make sure it is interest only for the full five years, and figure to sell the property before the loan expires, or make sure you refinance into a traditional loan WELL before the end of the interest only period. You want to be very sure to avoid a convertion on this loan.

Answer 9

Here's a simple explanation: You're only paying the interest on the loan. So if you take out a loan of $150,000.00 and make the payments for 5 years, you're still going to owe $150,000.00 in 5 years when you want to move. So all that money you pay on the loan is basically going to waste. Does that make sense?

Answer 10

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