There has been a great deal of talk about interest only loans, but no one has really explained what these new methods of financing are. Well, by the time you read all the way through this article, you should know what an interest only loan is an why they can be very dangerous. And the best part is you get to participate!
First, get a piece of paper and a pencil. Now, draw a rectangle. Now draw a straight line from the upper-left hand corner of the rectangle to the lower-right hand corner of the rectangle. You now have a rectangle divided into two triangles. Along the bottom of the rectangle write the label “time” and along the vertical side write “amount of money”.
Congratulations! You have now successfully diagrammed a standard mortgage cash flow! Pat yourself on the back on a job well done. Now, let’s explain the components of this thing by comparing it to a standard bond payment.
Here is a good place to explain the difference between a mortgage and a traditional bond payment. When someone gets a loan in the form of a bond, they make interest payments on a regular basis and repay the amount of the loan (the principal) at the end of the loan term. For example, suppose you sell a $1000 face amount bond at 10% interest for 10 years. The $1000 is the face amount of the loan, or the actual amount of money you are borrowing. This is also called the principal amount. The interest is the cost of the loan, or the price you pay to the lender for using the lender’s money. Over the 10-year life of the bond you will make annual interest payments in the amount of $100. But, when you make these interest payments, you don’t repay any of the principal or the amount of the loan. Instead you repay the lender the cost of the loan and save repaying the principal for the last payment.
To compare the above bond payments to a mortgage, we’ll return to our rectangle diagram. The lower triangle represents the interest component of the cash flow and the upper triangle represents in principal component of the cast flow. Now, remember the horizontal line represents time. So every time you make a mortgage payment, you pay a particular amount of interest and a particular amount of principal. At the beginning of the loan, you pay mostly interest and a little principal. At the end of the loan, you pay mostly principal and a little interest. This process is called amortization, or the process of dividing a particular stream of payments into interest and principal components over a particular period of time.
Now, notice with the standard mortgage diagram, you are paying a combination of interest and principal. Every time you make a payment, you are whittling down the face amount of the loan. So in year 10 of a 30-year mortgage, you should theoretically have a smaller face amount due to the lender.
With an interest only mortgage, you are only paying interest for the first part of the loan. While you are paying only interest, the principal amount remains unchanged.
Let’s use some numbers to illustrate this point. I’m going to use simple numbers that don’t represent actual amounts in order to make the illustration easier to understand.
Suppose you take out a $100,000 30-year mortgage at 10%. With a standard mortgage by year 10 you have repaid say 1/3 of the principal, or $33,000. However, by year 10 of an interest only loan you still have $100,000 outstanding on the loan. This is where the problem comes in with interest only loans. At some time in the future, the debtor may get hit with a massively escalating financing payment that will not go down.
This is an overly simplified version of the real thing, but the core principles are the same. Interest only loans make a traditional mortgage borrower more like a corporate borrower and making him more subject to the same problems as a corporate borrower.
Thank you so much for the explanation. The first time I heard about interest-only loans it set off alarms. It had that something-for-nothing taint that should always warn someone of possible danger. I think for a speculator/renovator it may well be a good short-term strategy: Buy a house, fix it up while paying interest only, then sell it for a higher price and pocket the difference. But, this only works if you can turn the house around in a couple of months. If it doesn’t sell then, you’re screwed.
Our neighbor back in Georgia crowed about how smart she was to essentially get a house while paying less than its monthly rental value. She “bought” at $160K and has put about $25K worth of improvements into the property. She figured when she was ready to sell, she’d get $200-220K+ and make a nice profit. Now, of course, there’s a similar house on the street selling for $175K. Ooops! She might end up with a $10K loss! Her mistake was thinking values would continue to grow over a five year period and she might have been right 10 years ago.
I think the housing market is going to tank any day. I live 35 miles outside of largish city in the Midwest. 10 years ago, this was a sleepy little town. 5 years ago a person could still get a decent house for less than $100,000. Today, new homes that are a relatively small 1300 square feet are selling for $215,000. It’s insane.
I never understood how anyone could pay for these houses, plus a couple of SUVs, plus some children. Guess interest only is one way, but it’s recipe for disaster. If the housing market falls, these people won’t have ANY equity in their homes, but will still be responsible for paying for them. They’d be better off renting.
I love your stuff.
As I read this one, something was bugging me. That part about using a straight line to plot the principle/interest split. That didn’t match my personal experience, nor what I’d recalled of what I’d been taught before, so I googled a bit, and found something that matched what I’d thought — its more of a curve.
Specifically to your point on at 1/3rd the way through a 30 yr mortgage, having 1/3rd paid off. It just doesn’t work that way.
Did you oversimplify your example, or did I miss something?
I took out a 69,000 30yr fixed loan for my first house. I held it for about 10-11 years. I had something like 59,000 left on it when I sold.
The details are that you pay the interest on the remaining amount of the loan, not on the total value. But the payment amount is set by the total loan amount. Is that right?
Anyhow, I still think zero-interest loans are death-in-a-handbasket. But not under the “no free lunch” clause, but more akin to automobile leases.
There are cases where auto leases are good bets (I’m told). I’d still never mess with one. Its too easy to end up upside-down on them.
If I had taken an interest only loan out on my property way back when, my payment would have been lower. But wouldn’t it be based on the total outstanding balance, which would never decrease? Whereas in a traditional loan, the payment never decreases, but the outstanding balance does.
I’m thinking that since my house appreciated 80% in ten years, had I had an interest only loan, I would have been paying the lower payments all along, and came out ahead that way. But at the sale, I’d have zero equity in it. So in other words, unlike automatically investing my money in the equity of my house (traditional mortgage), I would have kept it (as cash) to spend or invest in other ways. And at the time of sale, that means I’d have 10K less in equity to apply to the next house.
Now, I simply don’t believe we’ll see 80% appreciation in housing prices in the next 10yr stretch. Most of that was in the last few years during this “housing bubble”. The first couple years I owned it the labor market in town was weak, and if anything the value of the house fell a bit from when I bought it. And then it remained roughly flat for the next 3-5 years, or kept up with inflation. Then I got lucky with the double-digit increases in the last few years.
And if I’ve only lost 10% on the new house (weakness in the housing market has just/already hit the area), I’d be lucky.
I oversimplified the computations to get numbers that were easier to work with.
I just posted this comment on dailykos about the huge percentage
of interest only loans.
Great diary bonddad…sounds like it is a disaster
waiting to happen. 🙁
too–great! My education in economics continues apace. Isn’t the lure of interest only loans that you can take the money that doesn’t go to principal and invest it and get interest? I suppose a lot depends on how big a loan you take and how far the house’s value drops. In this climate we can’t count on real estate values staying high. But what if you take a smaller loan and invest the money you save in some guaranteed investment? But of course, nobody does that. I guess I am arguing myself out of my own objection. Everybody takes the money they save on the IO loans and buys more stuff–SUV’s, etc. So given human psychology and present day consumer culture, these loans are a bad idea.
The % of IO loan holders who actually invest the resultant savings wisely in order to prepare for the bigger payments down the road — or the % who actually pay off the principal anyway, just because they can — is probably on par with the % of new gym members who will still be going to that gym, faithfully, 2 or 3 times a week, one year later.
In theory, you are correct. The homeowner should invest the difference.
I have no idea what the statistics are of homeowners who do invest the difference. That would be interesting.
There has been some press stating the IOs are sold to homebuyers who would not qualify for a traditional fixed loan. If that is true, I would doubt a large percentage of the purchasers were investing the difference. But, that is just a hunch.
the people who’d like to sell you a loan are not necessarily looking after your best interest.
I was first introduced to the interest-only pkg by a broker who I’d done business with before and almost trusted (as much as one can trust those in the brokerage industry…okay, okay, trust is a bit contextual, ja?).
Anyway, I can still visualize her sitting across the (Broker Regulation) dark-wood desk from me cheerily explaining what a great option the interest-only was — particularly as our PDX housing prices are booming. The sell-in: “Even if you never pay a dollar of principal, the appreciation of the property will earn you money.”
What the hell? Call me a financial luddite, but sheesh, how can this be attractive to anyone? It’s your Personal Financial Apocalypse just around the corner (bubble burst or not).
Your diaries are great — so glad to see you posting here too.