Is Interest-Only Best For a Quick Turnover?

February 21, 2005, Revised December 28, 2005, June 4, 2009

An interest-only mortgage (IO) is one that grants the borrower an option to pay only the interest for the first 5-10 years. They can pay more if they wish, but they are obliged to pay only the interest. IOs have been around for a long time, but their recent popularity began when the option was attached to adjustable rate mortgages (ARMs).

Some of this popularity is based on a misperception. Since ARMs have lower rates than fixed-rate mortgages (FRMs), IOs are marketed as having low rates. Since a 30-year ARM with an IO option is priced lower than a 30-year FRM, for example, the lower rate is attributed to the IO. Few loan providers bother to mention that an ARM with the IO option is priced higher than the identical ARM without the option.

Every time I think I have shot down the last of the exaggerated claims for interest-only, a new one pops up. Here is the latest.

"I am planning to purchase a house and sell it within 1 or 2 years. I have been advised that an interest-only loan fits this situation best. Is that true?"

An interest-only (IO) is the instrument of choice in a quick turnover situation only if you are trying to maximize the amount of house you can buy, and are limited by your income. The IO option lowers the required initial payment, which allows you to qualify for a larger loan amount.

This is why buyers in markets undergoing strong price appreciation, who are looking for quick capital gains, gravitate to IOs – or to their big brother, the flexible payment (option ARM), which has even lower payments in the first year than an IO. See Option (Flexible Payment) ARMs.

The more expensive the house they can buy, the larger the expected capital gain. However, if you don’t need an IO to qualify for the house you want to buy, it is not the best choice in a quick turnover situation.

Your objective should be to minimize your total net costs over the 1-2 years you have the mortgage. Gross costs include points and settlement costs, which are paid upfront, monthly payments during the period, and interest lost on both upfront costs and monthly payments. Cost offsets that are deducted from the total consist of tax savings and reduction in the loan balance.

Whether or not the mortgage is an IO hardly affects total net costs. The payment is lower with the IO, but balance reduction, which is a cost offset, is eliminated.

To minimize total net cost over a short period, focus on finding the best combination of interest rate and rebate. A rebate is negative points, where the lender pays you for a higher rate instead of you paying the lender for a lower rate. A rebate will reduce or perhaps eliminate your upfront cost. When your time horizon is very short, paying a higher interest rate in exchange for a rebate is a good deal because you won’t be paying the rate very long.

To verify this, on December 17, 2005 I accessed a data base on wholesale prices posted by the major wholesale lenders – those that deal with mortgage brokers. I shopped (as if I were a broker) for a conforming loan of $300,000 on a $400,000 house purchase for a borrower with good credit, who can fully document adequate income and assets, and who will occupy the house as a permanent residence.

I found the best deal on 15 and 30-year fixed-rate mortgages (FRMs), and 3, 5 and 7-year adjustables (ARMs), each with and without an interest-only option, at the highest rebates offered. I then used calculator 9ci to find the total costs over a 2-year period in all 10 cases. As a check, I did the same thing at zero points and at the largest number of points offered.

The lowest cost mortgage over 2 years was the 15-year FRM with the highest rate-largest rebate combination. A close second was the 30-year FRM with the highest rate-largest rebate combination. On the ARMs, in contrast, costs were not materially different between the highest rate-largest rebate combination and the combination of a lower rate at zero points. In every case, switching to the IO version, whether FRM or ARM, increased the cost.

You can’t shop wholesale prices, but the relationships I found will carry over to web sites you can shop, such as those of the 7 Upfront Mortgage Lenders. If your time horizon is 2 years, your instrument of choice is a 15-year FRM with the largest rebate offered. If you can’t make the payment on the 15, your second choice is the 30-year FRM with the largest rebate. Neither ARMs nor IOs work as well.

Note that the calculation of total cost is impacted by your tax rate, which affects tax savings, and your savings rate, which affects interest loss on upfront costs and monthly payments. However, you can adjust everything to the particulars of your personal finances using calculator 9ci, Future Value Calculator: Comparing Two Fixed-Rate Mortgages.

This calculator offers an interest-only option, so if you aren’t convinced that interest-only won’t minimize your costs, you can test it yourself. Just remember that when you use the IO option, you must adjust the price as well. Adding an IO option always increases the price.

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