Evaluating interest-only mortgage

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Startled Cat
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Evaluating interest-only mortgage

Post by Startled Cat » Thu Jul 11, 2019 10:51 am

I'm struggling with a choice between a normal amortizing mortgage and the interest-only equivalent. I thought I'd turn to the collective wisdom of Bogleheads.

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
(For details on how these rates are available, see the excellent Relationship mortgage discounts thread).

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.

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Re: Evaluating interest-only mortgage

Post by bsteiner » Thu Jul 11, 2019 11:04 am

I like it because of the flexibility. Of course that only works if you don't spend the difference in the cash flow, or lose it in your investments.

I thought there was usually a larger difference in interest rates between traditional and interest-only mortgage loans.

Charon
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Re: Evaluating interest-only mortgage

Post by Charon » Thu Jul 11, 2019 11:06 am

I think this has more to do with psychology than finance. The simple fact of owning a home isn't a financially smart decision for most people in most of the country (renting + investing often has higher returns). Yet many of us want to own homes anyway.

I personally would get the amortizing loan, because I know that I dislike debt in a way that's somewhat irrational (focused on the debt amount rather than my net wealth). And I would avoid an ARM because I value predictability. It sounds like you have a very different approach, which is fine. As you say, we can't know what the future holds for your returns or future interest rates, so the financially optimal decision will only be clear in retrospect. As long as you know for sure that you won't spend the extra money and have lifestyle creep, interest-only could be a good choice for you. (Many people wouldn't have this self discipline, but you know yourself, and we don't.)

flarf
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Re: Evaluating interest-only mortgage

Post by flarf » Thu Jul 11, 2019 11:17 am

I don't think a 10-year amortizing ARM is significantly less risky than a 10-year interest-only ARM. The former comes due at a point where you still haven't made a significant dent in the principal. Either loan will put you in a painful situation if prevailing rates are drastically higher in 2029.

That said, I've only ever had ARMs, I think 7- and 10-year terms are right in the sweet spot, and I switched to interest-only about six years ago and haven't looked back. As long as you have the financial wherewithal to handle the risk, enjoy the dirt cheap money and go for it.

As far as your significant other's skepticism, neither of you are going to think about the mechanics of your mortgage once you leave the closing table -- it just becomes a line item in your bill pay.

targetconfusion
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Re: Evaluating interest-only mortgage

Post by targetconfusion » Thu Jul 11, 2019 11:18 am

Agree with Charon. It sounds like you're weighing the important things and so the decision may turn on whether you value optimal financial behavior or the feeling (and spouse's feeling) of safety and comfort, which has different prices to different people. "Interest-only" rings risky to most of us who remember it as a horsemen of the subprime mortgage debacle. But since you seem otherwise responsible (i.e., enough savings, free cashflow, not using it to buy more house than you could otherwise afford) it may be the financially optimal move.

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Startled Cat
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Re: Evaluating interest-only mortgage

Post by Startled Cat » Thu Jul 11, 2019 11:59 am

Charon wrote:
Thu Jul 11, 2019 11:06 am
The simple fact of owning a home isn't a financially smart decision for most people in most of the country (renting + investing often has higher returns). Yet many of us want to own homes anyway.
I completely agree! It so happens that I was never especially keen on homebuying. I take a pretty analytical, spreadsheet-oriented view of this sort of thing and thought renting would make more sense. My SO views it more emotionally. I only came around to the idea of homeownership when it became clear that she felt strongly about owning a home and I wouldn’t be able to change her mind.

Coincidentally, when I was coming to terms with the idea of buying a home, it occurred to me that an interest-only mortgage would make the prospect more palatable. From a cash flow perspective, it would be similar to renting, and wouldn’t involve diverting cash flow away from investments and towards debt payoff. I assumed that an interest-only mortgage would be a niche product and would be too expensive to make sense, but now that I have been offered one at a reasonable cost, you can see why I’m tempted.

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Re: Evaluating interest-only mortgage

Post by Bacchus01 » Thu Jul 11, 2019 12:08 pm

I would go for an interest-only and I have done so before. I'm not sure I'd do it on that spread, however. Seems close.

I wouldn't worry about the monthly payment. Worry about the monthly INTEREST payment. Invest the difference. Is that worth it on a post-tax basis? I haven't modeled it, but seems tight.

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Re: Evaluating interest-only mortgage

Post by grabiner » Thu Jul 11, 2019 6:14 pm

Startled Cat wrote:
Thu Jul 11, 2019 10:51 am
I'm struggling with a choice between a normal amortizing mortgage and the interest-only equivalent. I thought I'd turn to the collective wisdom of Bogleheads.

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
One point on a 30-year loan is about equal to an eighth of a percent on the interest rate, so the effective rate on the ARM is 0.09% higher, not 0.125%.
(For details on how these rates are available, see the excellent Relationship mortgage discounts thread).

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).
This is the same as the common question of Paying down loans versus investing. You are paying extra if you use the amortizing mortgage, just as if you paid down an existing loan.

You are correct that the fair comparison should be to a long-term investment, but it should also be to a low-risk investment. That is, if you take out the interest-only mortgage, and invest the difference in high-quality long-term municipal bonds, will you come out ahead or behind at the same risk level? (If you want to take more risk, you can invest in stocks instead, but you can do that even with the amortizing mortgage by moving some of your existing investments from bonds to stocks.)

And with long-term munis yielding 2.19% (Vanguard Long-Term Tax-Exempt), this doesn't seem to be worthwhile. Therefore, unless you get some value from the liquidity, I would prefer the amortizing mortgage.
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Re: Evaluating interest-only mortgage

Post by sc9182 » Thu Jul 11, 2019 8:26 pm

You must be refinancing existing $1.5 million mortgage debt. If you are buying new, TCJA limits mortgage interest tax deduction to $750k only. Just making it clear to thread readers!

Chances are - after 10 years of time frame things may have changed; such as kids went to college or got one or married etc, you may be empty nester! So, you may right size your home then by selling it. Either you take I/O loan or fully amortized one - you be practically in same boat - either enjoy cap gains , or book cap losses !! This fact can’t be determined a-priori.

you know what works the best !

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Re: Evaluating interest-only mortgage

Post by sf_tech_saver » Thu Jul 11, 2019 9:11 pm

Relative portfolio size vs. the mortgage would matter to me here.

I did a 7 year ARM (not IO) for the tax-deductible max (750k) because the overall portfolio is 4.3x that liability invested roughly 55% stocks 45% bonds. The bond + stock rally already has me well in the black after-tax benefits since I took out the loan in Jan.

In my case, I felt I could pay off the balance from either stocks or bonds at any point in the loan and still meet my retirement goals.

A mortgage is another target for rebalancing. If stocks rally the next three years you could take some risk off the table and pay off the loan.

If you paid off the debt with your portfolio would you still be on track to retire? If yes then ARMs (IO or normal) make a ton of sense to me. I even went for the 7 to save extra points. (I also didn't do IO to further cut the rate and increase the number of winning scenarios.)
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Startled Cat
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Re: Evaluating interest-only mortgage

Post by Startled Cat » Fri Jul 12, 2019 12:00 am

sf_tech_saver wrote:
Thu Jul 11, 2019 9:11 pm
Relative portfolio size vs. the mortgage would matter to me here.

I did a 7 year ARM (not IO) for the tax-deductible max (750k) because the overall portfolio is 4.3x that liability invested roughly 55% stocks 45% bonds. The bond + stock rally already has me well in the black after-tax benefits since I took out the loan in Jan.

In my case, I felt I could pay off the balance from either stocks or bonds at any point in the loan and still meet my retirement goals.

A mortgage is another target for rebalancing. If stocks rally the next three years you could take some risk off the table and pay off the loan.

If you paid off the debt with your portfolio would you still be on track to retire? If yes then ARMs (IO or normal) make a ton of sense to me. I even went for the 7 to save extra points. (I also didn't do IO to further cut the rate and increase the number of winning scenarios.)
Why is relative portfolio size a factor and which direction would it push you on IO?

I'm not sure how paying of the mortgage would change my path to retirement. It wouldn't change my net worth, but it would mean a smaller amount of financial assets and correspondingly more home equity. I guess you're asking whether I can take the liquidity hit?

It's hard to imagine paying off a loan at an effective rate of 1.44% as a rebalancing move. I can only imagine doing this in a deflationary scenario. At least with current rates, high quality munis yield more than this, and 10 year treasuries are darn close after tax. The liquidity has to be worth more than a few basis points... there's significant option value in case rates go up.

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Re: Evaluating interest-only mortgage

Post by sf_tech_saver » Fri Jul 12, 2019 12:38 am

Startled Cat wrote:
Fri Jul 12, 2019 12:00 am
Why is relative portfolio size a factor and which direction would it push you on IO?

I'm not sure how paying of the mortgage would change my path to retirement. It wouldn't change my net worth, but it would mean a smaller amount of financial assets and correspondingly more home equity. I guess you're asking whether I can take the liquidity hit?
I think your primary risk/decision is really around mortgage duration. Looking over my 7 year ARM docs now my rate can go as high as 8.3% over a 30 year pay-off period. If interest rates do crazy things when I'm looking to refinance I have a simple pay-off option.

Going interest only doesn't increase this risk dramatically as in the first 7 years I won't pay off that high a percentage of my loan. In the first year, the ratio is something like 1150 principle 2050 interest.

This relatively low ratio of principle to interest is exactly why I DIDN'T go with an IO loan. The lower rate on the loan came at a modest cost of 12k/750k in payment.

With strong liquidity, you can continue to chase the lowest possible interest rates on the debt wherever its best (5/7/10). I'm curious why you didn't show the 5/7 options as well (your rates seem really great btw!).
Startled Cat wrote:
Fri Jul 12, 2019 12:00 am
It's hard to imagine paying off a loan at an effective rate of 1.44% as a rebalancing move. I can only imagine doing this in a deflationary scenario. At least with current rates, high-quality munis yield more than this, and 10-year treasuries are darn close after tax. The liquidity has to be worth more than a few basis points... there's significant option value in case rates go up.
Yeah agree and in my situation, I'm better off with the money in a 7-year duration muni than the after-tax costs of the loan. This is clearly a no-brainer for the time being.

Perhaps where we differ is that I plan on retirement with a fully paid off house. If the market skyrockets over the next 7 years I might just call it a day and pay it all off. The smaller relative portion of the portfolio the mortgage becomes the less this matters to overall returns. I wouldn't want the toil of mortgage/refinance for 5% of my portfolio value!

*

One nice benefit of IO is that you don't have to do a 'money out' refinance to keep the max tax deductible balance. I'm already looking to refinance and having only paid $6k off I can no longer take the full $750 loan without the rate hit of 'money out.' :oops:
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Topic Author
Startled Cat
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Re: Evaluating interest-only mortgage

Post by Startled Cat » Fri Jul 12, 2019 9:10 am

sf_tech_saver wrote:
Fri Jul 12, 2019 12:38 am
With strong liquidity, you can continue to chase the lowest possible interest rates on the debt wherever its best (5/7/10). I'm curious why you didn't show the 5/7 options as well (your rates seem really great btw!).
I decided a 10 year ARM was best for me. I'm much more comfortable with a 10 year fixed rate period than a shorter one. I don't have large amounts of liquidity relative to the mortgage balance, but I'm pretty confident that I will in 10 years.

I'm not sure what the corresponding 7 year rate is in this case, but with some banks I looked at, 10/1 ARM had a lower rate than 7/1 ARM, which didn't really make sense.
sf_tech_saver wrote:
Fri Jul 12, 2019 12:38 am
One nice benefit of IO is that you don't have to do a 'money out' refinance to keep the max tax deductible balance. I'm already looking to refinance and having only paid $6k off I can no longer take the full $750 loan without the rate hit of 'money out.' :oops:
I thought only "acquisition debt" was deductible, and money from cash-out refis is not considered acquisition debt. This is a factor pushing me towards IO - it seems relatively difficult to reverse amortization.

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Re: Evaluating interest-only mortgage

Post by sf_tech_saver » Fri Jul 12, 2019 11:43 am

Startled Cat wrote:
Fri Jul 12, 2019 9:10 am

I thought only "acquisition debt" was deductible, and money from cash-out refis is not considered acquisition debt. This is a factor pushing me towards IO - it seems relatively difficult to reverse amortization.
True -- and good point in favor of IO.
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