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I see a lot of negative press regarding Interest Only mortgages.  People talk about them like they are the plague.  Most feel that if you took an interest only loan that you are inevitably in trouble and shouldn’t have bought a house in the first place. 

In some cases, they are right.  There are a lot of people who took out interest only mortgages who had no business doing so.  There are a lot of people who were coerced into a mortgage that they couldn’t afford.  There are a lot of people who will default on their mortgage.  But interest only mortgages will not necessarily be the cause of it.  Believe it or not, you typically don’t save that much money monthly by avoiding principle (the part you don’t pay initially in an interest only mortgage.)  Furthermore, most of the people defaulting on their mortgage right now were probably doing “light” or even “no” documentation loans.  Meaning that they, or their Loan Officer misled the Lender.   Basically, a lot of people got mortgages who shouldn’t have.  And that’s what’s causing the mortgage meltdown and credit crisis.  Not interest only loans. 

Let’s crunch some numbers to shed some reality on this subject.  Let’s assume that you are an honest person and can actually afford a $250,000 loan (100% Loan to Value) with a 6.25% amortized interest rate.  Let’s also assume that you will follow the normal trend of keeping this mortgage for 5 years (most people do something with their mortgage or move every 3-5 years.)  In 5 years you would have paid $75,700.74 in interest and $16,656.66 towards priciple.  $16,656.66!  That’s $3,331.33 per year!  Do you find that to be a significant amount of money?  Perhaps, let’s proceed.  Now, let’s try an interest only mortgage of $250,000 at 6.25%.  In 5 years, with an appreciation rate of 2%, you would have made $21,020.  If you took $278 ($3331.33 broken down monthly) a month and put it in an account with a 5% return you would make an additional $18,894 over the 5 year period.  So basically you just made $39,914 by using an interest only mortgage.  And that doesn’t factor in your tax savings.  This is often referred to as equity repositioning.  It’s not for everyone.  It’s not for the undisciplined.  Though if you are disciplined, than this is very much for you.

OK.  I know this is dry.  But it will make you money.  Over time, a lot of money.  Possibly enough money to retire on or buy your next home.  The power is the difference between simple interest (interest only) and compounded interest.  Here is the best example I can use:

If you borrow $100,000 at 7% simple interest for 15 years, you would be required to pay $105,000 in mortgage payments.  If you took that $100,000 and invested it with an average compounded return of 7% for that same 15 years, you would have $275,903.  You just made $170,903!  That’s the difference between simple and compounded interest.  And again, that doesn’t factor in the tax deduction.

Dry content?  $170,903 worth of dry content. 

If you made it through this post, congratulations.  I know it’s boring content, but it’s good to know if you’re willing to do the work.