Interest only mortgage: the conservative choice?

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HEDGEFUNDIE
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Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

For my 4000th post on Bogleheads, I will stay true to contrarian form and describe how refinancing to an interest-only mortgage turned out to be the conservative option for me.

My financial details:

SF Bay Area
Household income: Dual earner $550-600k
Home value: $1.8M
Loan balance: $1.2M
Investment portfolio: $1M

When I purchased this home two years ago, I happened to hit the very top of the Bay Area housing market. Since then I’ve had two appraisals, both of which confirmed that my home’s value has not budged since purchase. It’s unclear whether this trend will ever change.

So now I am stuck with a large illiquid undiversified stagnant asset that I am throwing $30k/yr into as principal paydown. In other words with a traditional mortgage I am concentrating more of my net worth into this albatross of a house.

In the meantime, while my and my wife’s careers have taken off, I can see numerous possibilities where our income could be reduced significantly, potentially by 25-40%.

These factors led me to explore an interest only mortgage at 2.5% for the first five years. This would allow me to:

1. Redirect $30k/yr from my house into my diversified stock and bond portfolio
2. In “bad times” give us a cushion of $30k/yr should our income drop drastically
3. In “normal times” allow us to earn market return on the $30k/yr, which should exceed 2.5%

I often read on Bogleheads that paying off one’s mortgage gives a psychological boost that cannot be quantified. It is not lost on me that I am going in the opposite direction, *delaying* my mortgage payoff for as long as possible. Psychologically I actually think of my situation as analogous to renting, paying mortgage interest and property taxes, which in my case coincidentally approximates the imputed rent my house would generate. So I am essentially renting, with a large illiquid undiversified stagnant asset along for the ride (baseball card collection, anyone?). But at least I’m not increasing that position. And I don’t think many would disagree that renting is the more conservative move in the Bay Area.

So there you have it - a interest only loan as the conservative Boglehead move!
Startled Cat
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Re: Interest only mortgage: the conservative choice?

Post by Startled Cat »

Interest only makes a lot of sense. I strongly considered doing 2.75% I/O instead of 2.625% with amortization, and narrowly went with the lower rate. In retrospect I think I should have gone with interest only, and will lean in that direction if/when I refinance again.
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simplesimon
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Re: Interest only mortgage: the conservative choice?

Post by simplesimon »

I like the decision but I wouldn’t call it conservative. Renters don’t have debt that they could be underwater on.

What’s stopping you from doing a cash out refinance?
mortfree
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Re: Interest only mortgage: the conservative choice?

Post by mortfree »

How much are you paying per year on the interest only loan? I didn’t see that mentioned.
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Nate79
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Re: Interest only mortgage: the conservative choice?

Post by Nate79 »

mortfree wrote: Sat Feb 22, 2020 4:24 am How much are you paying per year on the interest only loan? I didn’t see that mentioned.
He will pay 2.5% *$1.2M = $30k
KlangFool
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Re: Interest only mortgage: the conservative choice?

Post by KlangFool »

OP,

1) Is it an ARM?

2) Is it a non-recourse loan?

Frankly speaking, 30K per year is not good enough to make a difference for you.

KlangFool
WarAdmiral
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Re: Interest only mortgage: the conservative choice?

Post by WarAdmiral »

You are only 2 years into your home loan and 1/3 of your house is paid off. That's great!.

As you have found out, the more principal you pay in the early years (like first 5-7 years) the more you save on interest.

This $1.2M of loan is going to remain no matter what the stock market is doing or what the housing market is doing. It's a fixed target and must be paid off eventually - why delay ?

If i were you, i would stay the course and continue to pay additional principal every month and keep reducing the interest payments.
corysold
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Re: Interest only mortgage: the conservative choice?

Post by corysold »

WarAdmiral wrote: Sat Feb 22, 2020 7:49 am You are only 2 years into your home loan and 1/3 of your house is paid off. That's great!.

As you have found out, the more principal you pay in the early years (like first 5-7 years) the more you save on interest.

This $1.2M of loan is going to remain no matter what the stock market is doing or what the housing market is doing. It's a fixed target and must be paid off eventually - why delay ?

If i were you, i would stay the course and continue to pay additional principal every month and keep reducing the interest payments.
Why does it have to be paid off eventually? I'm assuming the OP is planning on paying interest only for the foreseeable future, then selling the home and paying off the loan.

The risk is the house value drops between now and then leaving him upside down, but I suppose he never "has" to sell if that is the case. The other risk is interest rates rising to 10% making the interest only portion beyond his income, especially if he has a job loss at the same time.

But seeing that California is a non-recourse state, the ultimate worst case is the OP walks away from the house and ruins his credit for 7 years, which in the grand scheme of things is a pretty small risk on a $1.8 million asset with $600,000 at risk.
petulant
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Re: Interest only mortgage: the conservative choice?

Post by petulant »

OP, thanks for sharing! How hard was it to find an interest-only lender? Were there any special hurdles? I have thought about this also and would like to run the numbers, but I haven't seen any publicly posted rates for interest-only mortgages since the late 2000s when ING Direct used to push interest-only balloon payment mortgages.
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midareff
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Re: Interest only mortgage: the conservative choice?

Post by midareff »

makes sense to me............ I'd like to find that here in S. Florida
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Sandtrap
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Re: Interest only mortgage: the conservative choice?

Post by Sandtrap »

This example supports the idea that what may seem like a great (or not great, or lousy) financial approach to something for "most" people does not hold true depending on individual financial circumstance.
There is no "one size fits all" financial solution for everyone.

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28fe6
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Re: Interest only mortgage: the conservative choice?

Post by 28fe6 »

Interest-only will not impact your net worth, assuming you invest or save the saved interest elsewhere. I think that interest-only can increase your liquidity but should have no net worth impact. Am I wrong?
ChrisC
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Re: Interest only mortgage: the conservative choice?

Post by ChrisC »

I had an 10 year interest only ARM in 2006 with a rate of 2.75% on a condo we purchased at the beginning of the real estate bust back then. We badly overpaid for the condo which was originally purchased for my MIL but we wound up living there for 7 years. It was pointless for us to build additional equity in a condo we were not going to stay for a long time and when the rate of appreciation for the condo was significantly lower than rates for other modest investments.

We sold the condo in 2014 for a few thousand dollars below our purchase price in 2006. The 10 year interest only ARM worked out fine for us.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

ChrisC wrote: Sat Feb 22, 2020 8:56 am I had an 10 year interest only ARM in 2006 with a rate of 2.75% on a condo we purchased at the beginning of the real estate bust back then. We badly overpaid for the condo which was originally purchased for my MIL but we wound up living there for 7 years. It was pointless for us to build additional equity in a condo we were not going to stay for a long time and when the rate of appreciation for the condo was significantly lower than rates for other modest investments.

We sold the condo in 2014 for a few thousand dollars below our purchase price in 2006. The 10 year interest only ARM worked out fine for us.
This is basically my situation. Good to hear it worked out for you.
mnnice
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Re: Interest only mortgage: the conservative choice?

Post by mnnice »

Since I have the advantage of hindsight I wish we had done something similar. 8-) We bought our current house ~5 years ago. We had/have a finite time horizon to live in it ~8 years.

Instead of an interest only loan we sold appreciated stock to finance the purchase and paid state income tax on it as regular income. 100 shares of well known stock (AAPL) would have paid for the house when we bought it. If we bought it today it would take just 53 shares. I tend to think of it in those terms as we did indeed use AAPL to finance. While our home has appreciation some most of that would have been eaten up by the interest in this system. We would have much better cash flow than renting and we could still personalize any way that was not super adverse to home value. I suspect that our net worth would be 10-15% more with the interest only loan

OTOH
Real estate and stocks sometimes move higher together, some time track in opposite directions, or both tank at once. Hindsight is 20/20
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ray.james
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Re: Interest only mortgage: the conservative choice?

Post by ray.james »

I understand the financial equation this thread is proposing. But I do not understand why anyone would chose a interest only loan and take on a risk of house as an asset. Why not rent? Alternatively this seems like a way to get non callable loan to invest even though it did not start that way. Probably a smarter thing than risking margin calls.

I do not know much about interest only loans. Is there a minimum equity in the home, before they are offered?
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

ray.james wrote: Sat Feb 22, 2020 6:45 pm I understand the financial equation this thread is proposing. But I do not understand why anyone would chose a interest only loan and take on a risk of house as an asset. Why not rent? Alternatively this seems like a way to get non callable loan to invest even though it did not start that way. Probably a smarter thing than risking margin calls.

I do not know much about interest only loans. Is there a minimum equity in the home, before they are offered?
Renting has the following drawbacks:

1. The rent can go up
2. Your lease could be terminated by the owner
3. You can’t do much to the property to improve quality of life

An interest-only loan can have a fixed rate for up to 30 years, during which time you have certainty of expenses. You also participate in any home value appreciation (but of course this is a risk as well).
Last edited by HEDGEFUNDIE on Sat Feb 22, 2020 7:51 pm, edited 1 time in total.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

Another poster PMed me this additional benefit of interest only loans that I did not consider.

When evaluating you for a below-market interest rate loan (“relationship mortgage”), banks will only consider the incremental liquid assets you might be able to move to them. Additional home equity doesn’t count. So an interest only loan frees up more cash to be plowed into taxable investments, which can then be moved around in search of the next low mortgage rate.

It’s a virtuous cycle.
JonnyB
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Re: Interest only mortgage: the conservative choice?

Post by JonnyB »

This is effectively the same thing as going to your bank and borrowing money to invest in the stock market, using your home equity as collateral. It is a leveraged stock investment. But at a very low interest rate.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

JonnyB wrote: Sat Feb 22, 2020 7:10 pm This is effectively the same thing as going to your bank and borrowing money to invest in the stock market, using your home equity as collateral. It is a leveraged stock investment. But at a very low interest rate.
Every mortgage is like this.

At least for interest only, you are making the conscious decision to tilt more to the stock market than to the housing market. The wiser choice, if you ask me.
ChrisC
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Re: Interest only mortgage: the conservative choice?

Post by ChrisC »

ray.james wrote: Sat Feb 22, 2020 6:45 pm I understand the financial equation this thread is proposing. But I do not understand why anyone would chose a interest only loan and take on a risk of house as an asset. Why not rent? Alternatively this seems like a way to get non callable loan to invest even though it did not start that way. Probably a smarter thing than risking margin calls.

I do not know much about interest only loans. Is there a minimum equity in the home, before they are offered?

I don’t know of any lender from an underwriting perspective who wouldn’t require an equity down payment whether for owner-occupied or investment property, unless there’s compensating deposit balances or other collateral. We put down 30% as a down payment and decided on 10 year interest only ARM amortized over 30 years.

This was simply cash flow driven as our monthly payments were so much lower than a 15 or 30 year fixed rate mortgage, which was important to us as we were also carrying another mortgage loan, and we were still paying real estate taxes and insurance on a third residence.

With the 10 year interest only ARM we could make additional equity/principal payments (which we did), get any potential upside appreciation, and deduct interest and real estate taxes. In short, we get the benefits of ownership and related tax deductions at a much lower debt service payment — made sense to us if we were not going to live there more than 10 years, before principal amortization kicked in. And you can hedge against staying longer or interest rate resets by making principal payments. If interest rate resets caused a spike in your rate, you could always refinance the ARM (or pay it off if you have the cash to do that). Our 2.75% rate stayed the same as interest rates were so low during our time period and we didn’t trigger any upward resets!
MrDrinkingWater
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Re: Interest only mortgage: the conservative choice?

Post by MrDrinkingWater »

Thank you for starting this topic and I appreciate your willingness to share what you are doing with all of us.

Deciding whether renting money or renting shelter is the smart thing to do can be difficult. Sometimes drilling into the details won't even provide a clear answer one way or another. If your shelter requirements are very specific and difficult to satisfy, there may not be any rentals available that match your need. The house you have meets your need. Selling and renting doesn't sound like an option. I think redoing your mortgage to an I/O loan makes sense for you.

Good luck! I always enjoy reading your posts.
softwaregeek
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Re: Interest only mortgage: the conservative choice?

Post by softwaregeek »

How are you getting 30k paydown? By my calculations in the early years you should have about 23k.

I know from previous posts we have very analagous situations and I went entirely in the opposite direction - I have the 30 year fixed.

But I'm convinced interest rates will rise over time. An increasing interest rate should hammer both equity and fixed income. A long term fixed mortgage is a partial hedge.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

softwaregeek wrote: Sun Feb 23, 2020 1:35 am How are you getting 30k paydown? By my calculations in the early years you should have about 23k.

I know from previous posts we have very analagous situations and I went entirely in the opposite direction - I have the 30 year fixed.

But I'm convinced interest rates will rise over time. An increasing interest rate should hammer both equity and fixed income. A long term fixed mortgage is a partial hedge.
$1,230,000 loan
30 year fixed at 2.375% (the lowest interest + principal rate I could find)
$4780 monthly payment
$26k first year principal paydown
$29k fifth year principal paydown

You and I have opposite convictions regarding interest rates. When I bought the house in April 2018 I went for a 5/1 ARM at 3.25%. In June 2019 I refinanced to another 5/1 at 2.65%. Now the 5/1 is at 2.375%.
dknightd
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Re: Interest only mortgage: the conservative choice?

Post by dknightd »

I've got to admit, I do not understand why you consider this conservative.
You have a 1.8M asset (which could change in value) and a 1.2M Loan (which will only go away when you pay it off).
So you already have 600K tied up.
Now you want to (or perhaps already have) taken an interest only loan for 1.2M.
A loan who's terms will change in 5 (or less) years. The only way I could consider this conservative is if you expected to move in 5 years or less.
Perhaps you consider it conservative because you will not be adding any more to this asset, for at least a few years?
If the goal was to have less money tied up in this asset, and more money in your other portfolio, did you consider a cash out refinance? Often you only have to leave 20%, not the 33% you have tied up.
I guess we have different ideas of what we consider conservative ;) :cheers:
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StevieG72
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Re: Interest only mortgage: the conservative choice?

Post by StevieG72 »

The worst part of this deal to me is what 1.8m will buy in SF Bay area. I guess it is all relative, as your income would likely not be as high in other areas of the country.
The danger is being upside down in your home if / when you decide to move.
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vinhodoporto
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Re: Interest only mortgage: the conservative choice?

Post by vinhodoporto »

You're making a big bet that interest rates stay low so that you can refi again when your 5/1 ARM starts to float. If rates go back up to traditional levels, you're going to be in a tough spot, especially if real estate values in your area fall at the same time because buyers can borrow less for a given income in a higher rate environment. This is more of an ARM issue than an IO issue, but the IO magnifies the risk because you're not building additional equity, and your (leveraged) stock portfolio could very likely to take a hit at the same time due to rising interest rates.

Your monthly payment could easily double (or worse) when your loan starts to float, and you might not be able to sell without losing a ton of equity. Can you handle that situation, especially if your income also declines 25-40% as you described as a possibility?

I don't disagree with your premise that going to IO route could be the conservative choice in some circumstances, as long as you have the ability to mitigate the downside risks. We did an IO loan to buy a primary residence in 2005 for similar reasons as you described and it worked out reasonably well for us. When we bought we were comfortable with the IO ARM because our projected income could cover the payments if the worse case happened when the loan started to float.
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Re: Interest only mortgage: the conservative choice?

Post by Dottie57 »

dknightd wrote: Sun Feb 23, 2020 8:25 am I've got to admit, I do not understand why you consider this conservative.
You have a 1.8M asset (which could change in value) and a 1.2M Loan (which will only go away when you pay it off).
So you already have 600K tied up.
Now you want to (or perhaps already have) taken an interest only loan for 1.2M.
A loan who's terms will change in 5 (or less) years. The only way I could consider this conservative is if you expected to move in 5 years or less.
Perhaps you consider it conservative because you will not be adding any more to this asset, for at least a few years?
If the goal was to have less money tied up in this asset, and more money in your other portfolio, did you consider a cash out refinance? Often you only have to leave 20%, not the 33% you have tied up.
I guess we have different ideas of what we consider conservative ;) :cheers:
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Carefreeap
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Re: Interest only mortgage: the conservative choice?

Post by Carefreeap »

I don't look at it as a conservative option either primarily because of the interest rate risk. I'm probably a lot older than the OP but I remember when FHA and VA rates were 19% in 1980. I got my real estate license in 1981 at age 18 when the interest rates dropped to 17%. Whoo-hoo!

It's true Bay Area prices did correct in 2008 but on the Peninsula prices went down in the 10%-20% range. Given the price of $1.8M I'm guessing OP has a modest home and would never be upside down on his loan. One thing he may have done by refinancing is converted to a recourse loan if he took any cash out during the refi.

I like the idea of the modest pay down of principle over the years as a kind of risk mitigation. Take your investment risks with your stocks.

Good luck with your course of action. I hope it works out for you!
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aristotelian
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Re: Interest only mortgage: the conservative choice?

Post by aristotelian »

Just do cash out refit or margin loan on your investments to get desired leverage. Personally, I see no need for more than 100% stock.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

People are getting hung up on the ARM risk. I don’t think interest rates will go up and I don’t think that’s a big bet I am making. It’s a topic I’ve explored at length for my Excellent Adventure and other threads.

In any case, Wells Fargo (among others) offers a 30-year fixed interest only mortgage product. Current rate is 3.5% locked in for 30 years.

Let’s stay on topic and discuss the interest only implications, not the direction of rates.
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

Carefreeap wrote: Sun Feb 23, 2020 10:45 am I don't look at it as a conservative option either primarily because of the interest rate risk. I'm probably a lot older than the OP but I remember when FHA and VA rates were 19% in 1980. I got my real estate license in 1981 at age 18 when the interest rates dropped to 17%. Whoo-hoo!

It's true Bay Area prices did correct in 2008 but on the Peninsula prices went down in the 10%-20% range. Given the price of $1.8M I'm guessing OP has a modest home and would never be upside down on his loan. One thing he may have done by refinancing is converted to a recourse loan if he took any cash out during the refi.

I like the idea of the modest pay down of principle over the years as a kind of risk mitigation. Take your investment risks with your stocks.

Good luck with your course of action. I hope it works out for you!
This is incorrect. If I did a cash-out refi, only the cash-out portion would be recourse, the rest of the loan would remain non-recourse.

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MathWizard
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Re: Interest only mortgage: the conservative choice?

Post by MathWizard »

You are leveraging using your mortgage to invest rather than to buy a home. Leverage amplifies the upside, but also the downside.

I think you are trying to convince yourself that it is conservative, and therefore the safest/wisest move.

I don't agree that it is a conservative move.

You are making close to half a million a year. You are likely to be able to withstand the effect if it goes badly, but in your situation, I would not do it.
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sergeant
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Re: Interest only mortgage: the conservative choice?

Post by sergeant »

My definition of conservative is having no debt so I would say this is not the conservative choice. I don't think it will make a big difference in your net worth. I do think that you may be correct that your home value will be stagnant.

Have you actually done this?
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

MathWizard wrote: Sun Feb 23, 2020 11:18 am You are leveraging using your mortgage to invest rather than to buy a home. Leverage amplifies the upside, but also the downside.

I think you are trying to convince yourself that it is conservative, and therefore the safest/wisest move.

I don't agree that it is a conservative move.

You are making close to half a million a year. You are likely to be able to withstand the effect if it goes badly, but in your situation, I would not do it.
Sometimes it’s helpful to lay out one’s options and consider them rationally, instead of going on gut feeling.

I have three options in front of me:
1. Accelerate principal payments (what I see Bogleheads do all the time)
2. Stick to the normal principal payoff of a 30 year loan
3. Go with interest only loan, delay paying off principal as long as possible.

It’s important to note that my income, my home value, stock valuations and interest rates will go up or down on their own, independent of which of these three paths I choose.

Let’s go with the worst case: my income is cut 40%, the stock market crashes, my home value declines.

In this scenario, how exactly does option #1 or #2 help me? I still have a loan that I can’t pay back, and now I have given the bank more equity (some of which has gone up in smoke, btw) to repossess than if I had just turned in the keys.
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Re: Interest only mortgage: the conservative choice?

Post by aristotelian »

Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return? With 100% stock portfolio, you might take 5-6 years to break even after a market crash. With the mortgage drag, it might take 10-12 years.
Last edited by aristotelian on Sun Feb 23, 2020 11:44 am, edited 1 time in total.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

aristotelian wrote: Sun Feb 23, 2020 11:43 am Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return?
What is the risk-adjusted return of home equity, and how does that compare to ~4%?
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Re: Interest only mortgage: the conservative choice?

Post by aristotelian »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:44 am
aristotelian wrote: Sun Feb 23, 2020 11:43 am Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return?
What is the risk-adjusted return of home equity, and how does that compare to ~4%?
100% chance of saving 2.5% every year.
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HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

aristotelian wrote: Sun Feb 23, 2020 11:46 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:44 am
aristotelian wrote: Sun Feb 23, 2020 11:43 am Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return?
What is the risk-adjusted return of home equity, and how does that compare to ~4%?
100% chance of saving 2.5% every year.
Hardly. The volatility of Bay Area real estate is at least as much as the stock market. Also loans are non-recourse.
aristotelian
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Re: Interest only mortgage: the conservative choice?

Post by aristotelian »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:48 am
aristotelian wrote: Sun Feb 23, 2020 11:46 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:44 am
aristotelian wrote: Sun Feb 23, 2020 11:43 am Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return?
What is the risk-adjusted return of home equity, and how does that compare to ~4%?
100% chance of saving 2.5% every year.
Hardly. The volatility of Bay Area real estate is at least as much as the stock market. Also loans are non-recourse.
Whether you do traditional mortgage or interest only, you already own the house. The question is the risk adjusted return of your down payment savings you 2.5% vs investing the cash in stocks with 2.5% drag, no?
Topic Author
HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

aristotelian wrote: Sun Feb 23, 2020 11:53 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:48 am
aristotelian wrote: Sun Feb 23, 2020 11:46 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:44 am
aristotelian wrote: Sun Feb 23, 2020 11:43 am Another way to think about this is in terms of risk-adjusted return. With 100% stock, let's say you are accepting risk of 50% drawdown in exchange for average returns of perhaps 6-7% real. If you are leveraging interest-only mortgage, you have more cash to deploy, but it is costing you 2.5%, making your expected return 3.5-4.5%. Is it worth taking that kind of risk for only ~4% expected return?
What is the risk-adjusted return of home equity, and how does that compare to ~4%?
100% chance of saving 2.5% every year.
Hardly. The volatility of Bay Area real estate is at least as much as the stock market. Also loans are non-recourse.
Whether you do traditional mortgage or interest only, you already own the house. The question is the risk adjusted return of your down payment savings you 2.5% vs investing the cash in stocks with 2.5% drag, no?
You would be right, except:

1. My expected returns in the market are over 6-7% as I use leveraged securities
2. CA is a non-recourse state so there is a (small) chance that I walk away from the loan if it goes underwater, making the “guaranteed” return of paying off the loan somewhat lower than 2.5%
dknightd
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Re: Interest only mortgage: the conservative choice?

Post by dknightd »

Carefreeap wrote: Sun Feb 23, 2020 10:45 am I don't look at it as a conservative option either primarily because of the interest rate risk. I'm probably a lot older than the OP but I remember when FHA and VA rates were 19% in 1980. I got my real estate license in 1981 at age 18 when the interest rates dropped to 17%. Whoo-hoo!

It's true Bay Area prices did correct in 2008 but on the Peninsula prices went down in the 10%-20% range. Given the price of $1.8M I'm guessing OP has a modest home and would never be upside down on his loan. One thing he may have done by refinancing is converted to a recourse loan if he took any cash out during the refi.

I like the idea of the modest pay down of principle over the years as a kind of risk mitigation. Take your investment risks with your stocks.

Good luck with your course of action. I hope it works out for you!
+3
If you value a bird in the hand, pay off the loan. If you are willing to risk getting two birds (or none) from the market, invest the funds.
dknightd
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Re: Interest only mortgage: the conservative choice?

Post by dknightd »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 10:49 am People are getting hung up on the ARM risk. I don’t think interest rates will go up and I don’t think that’s a big bet I am making. It’s a topic I’ve explored at length for my Excellent Adventure and other threads.

In any case, Wells Fargo (among others) offers a 30-year fixed interest only mortgage product. Current rate is 3.5% locked in for 30 years.

Let’s stay on topic and discuss the interest only implications, not the direction of rates.
You are paying interest. The bank is collecting interest. You might win. You might loose.
If you value a bird in the hand, pay off the loan. If you are willing to risk getting two birds (or none) from the market, invest the funds.
MoneyMarathon
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Re: Interest only mortgage: the conservative choice?

Post by MoneyMarathon »

HEDGEFUNDIE wrote: Sat Feb 22, 2020 1:17 am 1. Redirect $30k/yr from my house into my diversified stock and bond portfolio
2. In “bad times” give us a cushion of $30k/yr should our income drop drastically
3. In “normal times” allow us to earn market return on the $30k/yr, which should exceed 2.5%
There's no real reason to "build equity" (illiquid) in equal monthly installments (liabilities). Loans are already designed to let you pay down principal whenever you want, so you can build that equity without locking yourself in to the monthly payment part of it.

The 2.5% interest savings of paying it down is effectively tax-free income, though (above the $750k / $1M limits), which is pretty good on a pre-tax basis (might be equivalent to 4% yield), so the question about paying down at all is mostly about whether you want to deleverage or not. Because if you want to leverage up, you can't beat it (other loans have higher interest). But if you want to deleverage, you also can't beat it (munis and other alternative fixed income don't pay as much). There is a point at which you're losing out on itemized deductions by paying down the loan any more, though, if you like to itemize.

The higher your net worth, the more you are able to "self insure" and avoid paying for the insurance of fixed rate terms - if you have the flexibility to pay it off, then if we landed back in Carter era inflation, you still have a nominally sized debt you can wipe out with your assets. You're not stuck paying increasing interest costs each year (or increasing rent) if you have the financial flexibility to eliminate the loan. There's an opportunity cost to being forced to pay down the loan (which could be at very favorable terms if rates go up), but there's also a cost to buy the insurance (sounds like the cost is a whopping 40% more in interest or $12,000 a year).

The peace of mind of owning a home outright makes sense. Having a home that expensive forces you to put a price on peace of mind. It's a lot easier not to think about the trade offs this way on a less expensive house.
Topic Author
HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

dknightd wrote: Sun Feb 23, 2020 12:23 pm
HEDGEFUNDIE wrote: Sun Feb 23, 2020 10:49 am People are getting hung up on the ARM risk. I don’t think interest rates will go up and I don’t think that’s a big bet I am making. It’s a topic I’ve explored at length for my Excellent Adventure and other threads.

In any case, Wells Fargo (among others) offers a 30-year fixed interest only mortgage product. Current rate is 3.5% locked in for 30 years.

Let’s stay on topic and discuss the interest only implications, not the direction of rates.
You are paying interest. The bank is collecting interest. You might win. You might loose.
Ok, so your answer is I should liquidate my $1M in retirement savings and pay off my mortgage instead?
ktd
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Re: Interest only mortgage: the conservative choice?

Post by ktd »

Interest only loan makes a lot of sense in your situation. I would totally do it.
getjiggy
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Re: Interest only mortgage: the conservative choice?

Post by getjiggy »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 12:07 pm
aristotelian wrote: Sun Feb 23, 2020 11:53 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:48 am
aristotelian wrote: Sun Feb 23, 2020 11:46 am
HEDGEFUNDIE wrote: Sun Feb 23, 2020 11:44 am

What is the risk-adjusted return of home equity, and how does that compare to ~4%?
100% chance of saving 2.5% every year.
Hardly. The volatility of Bay Area real estate is at least as much as the stock market. Also loans are non-recourse.
Whether you do traditional mortgage or interest only, you already own the house. The question is the risk adjusted return of your down payment savings you 2.5% vs investing the cash in stocks with 2.5% drag, no?
You would be right, except:

1. My expected returns in the market are over 6-7% as I use leveraged securities
2. CA is a non-recourse state so there is a (small) chance that I walk away from the loan if it goes underwater, making the “guaranteed” return of paying off the loan somewhat lower than 2.5%
IF you are getting interest only refi for 2.5%, with solid home equity already built in for RE uncertainty cushion - this a no-brainer to park the principal payment savings for mkt investments for better returns. My situation is similar to OP and personally have been looking at this too but not seeing good rates better than 3.375 % for 7/1 arm interest only. Currently have 2.75% on 7/1 arm but going to interest only will ‘save’ ~$15k per year to deploy in market for higher returns. Also have 40% home equity built in for uncertainties. And remember we always have the option to pay up principal with any bonus or vesting payouts IF I want to (though I don’t see merit of that).

Is anyone else seeing such low rates for interest only as OP?
dknightd
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Re: Interest only mortgage: the conservative choice?

Post by dknightd »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 12:28 pm
dknightd wrote: Sun Feb 23, 2020 12:23 pm
HEDGEFUNDIE wrote: Sun Feb 23, 2020 10:49 am People are getting hung up on the ARM risk. I don’t think interest rates will go up and I don’t think that’s a big bet I am making. It’s a topic I’ve explored at length for my Excellent Adventure and other threads.

In any case, Wells Fargo (among others) offers a 30-year fixed interest only mortgage product. Current rate is 3.5% locked in for 30 years.

Let’s stay on topic and discuss the interest only implications, not the direction of rates.
You are paying interest. The bank is collecting interest. You might win. You might loose.
Ok, so your answer is I should liquidate my $1M in retirement savings and pay off my mortgage instead?
I would choose the 30 year fixed term loan. And refinance, or pay off, as desired or needed.
If you value a bird in the hand, pay off the loan. If you are willing to risk getting two birds (or none) from the market, invest the funds.
aristotelian
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Joined: Wed Jan 11, 2017 8:05 pm

Re: Interest only mortgage: the conservative choice?

Post by aristotelian »

HEDGEFUNDIE wrote: Sun Feb 23, 2020 12:07 pm You would be right, except:

1. My expected returns in the market are over 6-7% as I use leveraged securities
2. CA is a non-recourse state so there is a (small) chance that I walk away from the loan if it goes underwater, making the “guaranteed” return of paying off the loan somewhat lower than 2.5%
The point is simply that your risk-adjusted returns will be 2.5% less than whatever they would be investing cash with no loan. If you are willing to accept those returns for the risk, that is a valid judgment call.

Another consideration would be whether 2.5% drag is the cheapest way to get your desired leverage. Would need more info to think that through.
Topic Author
HEDGEFUNDIE
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Re: Interest only mortgage: the conservative choice?

Post by HEDGEFUNDIE »

aristotelian wrote: Sun Feb 23, 2020 12:50 pm
HEDGEFUNDIE wrote: Sun Feb 23, 2020 12:07 pm You would be right, except:

1. My expected returns in the market are over 6-7% as I use leveraged securities
2. CA is a non-recourse state so there is a (small) chance that I walk away from the loan if it goes underwater, making the “guaranteed” return of paying off the loan somewhat lower than 2.5%
The point is simply that your risk-adjusted returns will be 2.5% less than whatever they would be investing cash with no loan. If you are willing to accept those returns for the risk, that is a valid judgment call.

Another consideration would be whether 2.5% drag is the cheapest way to get your desired leverage. Would need more info to think that through.
2.5% is a no-brainer

3.5% would be tough
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