The loan is a 10/1 jumbo ARM, and the options are:
- 2.625% for the first 10 years, amortizing (monthly payment ~$5,825), 0.125% lender credit
- 2.750% for the first 10 years, interest only (monthly payment ~$3,339), 0.275% lender credit
In both cases interest would be fully tax-deductible.
I modelled after-tax cash flows and found it takes an after-tax rate of return on investments of 2.5%-3% for the interest-only loan to make sense. The absolute mortgage rate is very low, but there's extra interest on the mortgage balance due to the slightly higher interest-only rate, which the investment returns have to compensate for. 2.5-3% is far from guaranteed, but it's only slightly higher than inflation and I suspect it's very likely to be attainable in the long term. My sense is that if someone offered me 3% after tax guaranteed, I'd probably take it if, but only if it was a liquid investment (and the amortizing loan definitely is not).
The lower closing costs also favor the interest-only option. I've found myself refinancing more frequently than I expected to, due to the recent trend in rates. If I end up refinancing within the next 2 years, the interest-only option is better. I have a preference for minimizing closing costs.
I/O is also superior from liquidity and cash flow perspectives. Once a dollar of mortgage debt is paid down, it's tax-inefficient to pull that home equity back out (absent selling the property), so I like the idea of leaving the mortgage balance as high as possible. Cash flow isn't a big issue, but in the hypothetical event that my significant other or I lost a job or had major unexpected expenses, a lower required mortgage payment would be convenient.
Since this is an ARM, I'd hope to refi sometime within the fixed-rate period, otherwise the adjustment will probably significantly increase the rate. But even if we refi'd into an amortizing loan, any investments we made from cash flow that would otherwise have gone to monthly principal payment up to that point would probably not need to be liquidated and could continue to compound. Thus I think the right time horizon for evaluating the choice is the length of time we own the home, not the lifetime of this particular loan.
The amortizing loan is definitely less risky. There's already some risk in taking an adjustable rate. Going interest-only magnifies that by causing a larger balance to potentially be subject to the rate adjustment. There's also the risk of distoring our asset allocations to aim for beating that 3% number, taking on even more risk in the process. Additionally, the forced savings that come from an amortizing loan could be a good thing. I'm confident we have the discipline to save on our own, but it would put a check on our behavior.
I lean towards interest-only. I think we would probably make up the interest rate difference by investing the cash flow difference, and the lower closing costs and better liquidity/cash flow sweeten the deal a bit. My significant other is skeptical of interest-only (she isn't as fond of debt), but is willing to consider it. My sense is that it probably doesn't matter much in the long run, and could mean a difference of a few tens of thousands of dollars in either direction over 10 years. On one hand, I'm tempted to defer to her preference, keep things simple, and avoid taking on extra risk. But I can imagine looking back several years from now and regretting sinking a bunch of cash into paying off cheap, tax-deductible debt instead of investing it... or looking back in one year with the 10 year treasury at 1.5%, doing yet another refinance, and wishing I had opted for lower closing costs.