Paying more on interest-only loan

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lovingit

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Let's say two people take out two different types of loans of the same loan amount.

person A - 30 year fixed at 4%.  Monthly payment is $5000.  Estimate $1500 goes towards principal and $3500 goes toward interest per month.

person B - interest only at 3%.  Monthly payment is $2500.

Assuming you want to stay in the house and not flip it.  Isn't it better to get a interest-only loan and pay the difference toward principal?  So person B can pay $2500/month toward interest and pay another $2500 toward principal.  Person B would pay the same total $5000/month payment as person A, but person B pays $1000 more toward principal ($1500 vs $2500)  I'm not sure the exact mechanics on how the interest-only loan works but understand that the interest only lasts for 5 years and then does it become a 30 year loan?  By paying more toward principal even with an interest-only loan, isn't person B better off ?
 
I think the first question to answer is "What am I planning to do with the extra money I'm not paying towards principal?". 

5/1, 7/1, and 10/1 IO ARM loans are 30 year mortgages where the first 5, 7, and 10 yrs are fixed. After the initial fixed period expires, these loans flip to a variable rate for the remaining 25, 23, or 20 years of the loan. Parallel to this rate change, the amortization for most of these loans is deferred (interest only payments required) until 10 years pass. For the remaining 20 years the loan will require principal and interest payments.

Example:

5/1 ARM
Yrs 1-5. 4% IO Payment
Yr 6 - 4.125% IO Payment
Yr 7 - 3.99% IO Payment
Yr 8 - 4.875% IO Payment
etc until year 10. The rate continues to vary year over year - 10, 11, 19, 28 etc, however the remaining payments for those years flip to P+I only.

Hope this helps,

SGIP
 
Soylent Green Is People said:
I think the first question to answer is "What am I planning to do with the extra money I'm not paying towards principal?". 

5/1, 7/1, and 10/1 IO ARM loans are 30 year mortgages where the first 5, 7, and 10 yrs are fixed. After the initial fixed period expires, these loans flip to a variable rate for the remaining 25, 23, or 20 years of the loan. Parallel to this rate change, the amortization for most of these loans is deferred (interest only payments required) until 10 years pass. For the remaining 20 years the loan will require principal and interest payments.

Example:

5/1 ARM
Yrs 1-5. 4% IO Payment
Yr 6 - 4.125% IO Payment
Yr 7 - 3.99% IO Payment
Yr 8 - 4.875% IO Payment
etc until year 10. The rate continues to vary year over year - 10, 11, 19, 28 etc, however the remaining payments for those years flip to P+I only.

Hope this helps,

SGIP
Click to expand...

I know with the ARM, you also have the option to pay extra toward principal.  But I'm curious with comparing a lower payment option (interest-only loan) and consistently paying extra toward principal every month vs a traditional 30 year fixed loan to see what the outcome would be at the end of 6 years when the interest only option expires.  You can always refi, assuming rates haven't skyrocketed then. 

But going back to the original question, wouldn't person B have a smaller principal at the end of 6 years, when the interest only option changes to a traditional loan, than person A, because person B was paying the extra $2500/month toward principal, vs person A who is only paying $1500/month toward principal?
 
Pay less with more risk and pay more for less risk.  If you have an exit route, choose the pay less option.
 
ps9 said:
Pay less with more risk and pay more for less risk.  If you have an exit route, choose the pay less option.
Click to expand...

When you say risk, you mean house depreciating (which doesn't usually happen in Irvine) and interest rates rising (which could happen)?

Let's say loan amount, for ease of numbers, is $1,000,000

At the end of 5 years, Person A would have paid $1,500 * 60 months = $90,000 towards principal with $3,500 * 60 months = $210,000 towards interest.  The principal balance would be $910,000
At the end of 5 years, Person B would have paid $2,500 * 60 months = $150,000 towards principal with $2,500 * 60 months = $150,000 towards interest..  The principal balance would be $850,000

Person B looks in a better position with options to have a lower monthly payment and a lower principal balance.  They would have a 25 year traditional P+I payment now, which could double their monthly payment, but they have paid less toward interest and more toward principal.  They could just refi.
 
Refi but at what rate.  We've been living la vida loca rates but no one can predict 5 or 7 or 10 years from now.  Today's rate for 30 yr fixed for that amount let's say is 3.5%.  Could 10 years double to 7% or even more?  Who knows. Would you risk it?
 
Where you guys pulling numbers from?

While I'm confident you can do better than bankrate rates, on a jumbo, I see 30 years available for 3.75% with site average of 4.23 since everybody offers one.  For the io arm, I see a site average of 3.77% and only a handful offering.

For conforming, I see plenty of 30 year or regular Arms, even less IO and the rates are even tighter together.
 
nosuchreality said:
Where you guys pulling numbers from?

While I'm confident you can do better than bankrate rates, on a jumbo, I see 30 years available for 3.75% with site average of 4.23 since everybody offers one.  For the io arm, I see a site average of 3.77% and only a handful offering.

For conforming, I see plenty of 30 year or regular Arms, even less IO and the rates are even tighter together.
Click to expand...

Your looking at the wrong place (website/lender) or your criteria you enter.

I don't know.
 
nosuchreality said:
Where you guys pulling numbers from?

While I'm confident you can do better than bankrate rates, on a jumbo, I see 30 years available for 3.75% with site average of 4.23 since everybody offers one.  For the io arm, I see a site average of 3.77% and only a handful offering.

For conforming, I see plenty of 30 year or regular Arms, even less IO and the rates are even tighter together.
Click to expand...
WF shows 3.5 jumbo with 25% down.
 
With mortgages Devil is in the details.  Interesting WF shows conforming rates are higher than Jumbo. Which seems odd.

Again, not seeing the 3% IO rate. Seeing sub 3% arm rates but those aren't IO loans.

Using bank rates numbers I get a wash between the IO rate and the 30 year which makes sense to me as any gap would get flushed by arbitrage.

For the straight 5/1 or 7/1 ARM versus 30y fixed after five years I get the ARM in a better position (good chunk lower balance) but a much less dramatic payment difference of $550/month. So they're facing a recast having pocketed an extra $20k and have a $880ish k loan balance

Which also makes sense as its a much less risky loan for the lenders
 
Bankrate's data is rated "A" for "Avoid". Since it's a "pay to play" site, their numbers are always suspect.

Yes, sub 3.5 30 fixed and sub 3.% IO ARM's are available, but be careful of some of the cash reserve, LTV, FICO score, DTI, and other factors that will make it nearly impossible to obtain but only for the highest quality borrower.

My .02c

SGIP
 
Even sub 3 on IO and sub 3.5 on fixed for extreme qualification is still about a wash.  Over the five years, the IO saves a little more than was paid on principal.

How's the rate on a plain 5 year ARM for that same qualification?
 
So when the initial 5 year IO loan is up, what happens?  Does it become a 25 year loan and converts to whatever the market is then?
 
lovingit said:
So when the initial 5 year IO loan is up, what happens?  Does it become a 25 year loan and converts to whatever the market is then?
Click to expand...

No and yes, it recasts and re-amortizes.  An ARM rate is made up of a benchmark rate plus a margin.  So it essentially goes to the non-teaser rate ARM rate until the next adjustment. Many are tied to the LIBOR; COFI or CMT are common.  As in the loan docs will say when they recast, how big the initial recast can be and how big the subsequent recasts can be along with the benchmark and the margin.  They also clarify how frequently the rate adjusts and the initial, interim and lifetime caps on the adjustment.  i.e. Today a quicky front page check of WF shows a 5/1 ARM (not IO) at 2.875% shows the margin rate at 2.25% with current index at 1.125% (looks like 1 year LIBOR to me) and a lifetime cap of 5%. No initial or intermediate limit listed so lets assume 5% on initial.

If it recast today, the loan would be like a 25 year 3.375% loan until the next adjustment period, which could be annually or even as short as monthly.  If it was an annual recast, then today it would be like a 25 year 3.375% loan, then next year it would recast and recalculate like a 24 year loan at the index plus margin.  If it's been like the last three years or so the rate as been really flat so probably recast around 3.375%.  It could, if the index rate shots up (look at the LIbOR chart for mid 2000s or mid 90s), could adjust to 25 year 8.375%. So as long as you're confident you'll have the income and debt ratios in 3-5 years to refinance to either another ARM or 30y fixed, no worries.  If your index is going nutz, the refi ARMs are going nutz, 30 year may or may not.

It's that last scenario that scares most.  Here's the LIBOR history chart.  The spike at the end of 94 is 4.125% jump between Jan and Dec.
wsj_libor.gif


 
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