Never heard about an interest only mortgage? Well, it’s exactly what it sounds like – it’s a mortgage where each month you just pay the interest, you don’t pay back any of the capital, the capital is due at the end of the term.
On a traditional mortgage, if you take out a 25-year term, then over those 25 years at the end of that time you don’t owe the bank anything. Each month you’ll be paying an interest and a little bit of the capital, that ratio of interest to capital changes over the life of that mortgage at the start, you’re paying a very small fraction of the capital and at the end your last payment is 90% or 99% capital and of course, over that time period you pay back the entire loan.
An interest only mortgage basically means that each month you’re just paying the interest – if you take out $100,000 loan over 25 years, in 25 years you still owe the bank $100,000.
So, the question is, is that a good thing to do?
Now, these types of mortgages aren’t available in all jurisdictions around the world and they’re usually available from banks when they’re confident of the market. When the market is bullish, you’ll see banks offering interest only mortgages and I love them! Why? Because, if you think about it, each month you’re paying less money from your property income to the bank.
Let’s take an example, let’s say you’re making $1,000 in rental income and each month your, if you have a repayment mortgage, repayments might be $800 a month. This leaves you with a profit of $200 and $800 is going to pay back the capital and the interest, that’s a normal mortgage.
With an interest only mortgage you’re not paying back any of the capital
Your payments back to the bank are lower, so rather than paying $800 a month you might be only paying $550 and so you’re left with a larger amount of profit at the end of each month in terms of cash flow. Don’t forget that at the end of 25 years you’ve got to pay back the bank their money.
The good thing is that $100,000 today is not the same value that $100,000 will have 25 years from now, maybe in 25 years because money devalues that $100,000 might be a cup of coffee or it might be a meal for two or it might be just one month’s rental income from that property.
The question is should you go for an interest only mortgage?
And the answer is: if you can make more money from the money that you save rather than paying the bank back their money, if you can invest wisely, then yes. Every month when you pay back the bank, you’re effectively reducing the amount of money you owe, it’s like an investment. So, in our example we’re basically saving $250 a month extra by not paying back to the bank.
So, the question is can we use that $250 in an investment each month that’s going to be worth more than the $100,000 that I owe the bank in 25 years? And if I can invest that money more effectively than paying off my loan then I should do that every single time?
Using our example, how much of an ROI do you need on that $250 over a year? It’s only 3,4 or 5% which is a small percentage. So long as you can make more than the interest rate on your mortgage then it’s a good idea to go for the interest only mortgage.
Analyzing the numbers
Now, that sounds a little bit complicated and it’s always beneficial to analyze these kinds of numbers in Excel where it’s very easy to calculate interest because it’s a simple function. For example, if I were to say what’s 10% interest on a $1000? Well that’s 10% x $1000 which gives us $100 but what if you have to calculate your monthly repayments over 25 years on a 7% mortgage still starting at $100,000? It’s more complicated.
This is where a great function in Excel comes in handy it’s called the PMT function, look it up, analyze it, it’s a very simple formula to work out your monthly payments and it will help you work out what kind of ROI do you need to make in order to go for the interest only mortgage.
Understanding your investments
It is a little bit complicated, a little bit advanced but it’s important because number 1: if you’re making more cash on a monthly basis your investments are safer, you can hold that investment longer and of course make more money, so it’s very critical to understand whether you should go for a repayment mortgage or an interest only mortgage.
My encouragement for you is to go and open Excel or even Google Sheets, most spreadsheet programs have this function called PMT, if you don’t know how to do it/use it, look it up on Google, it’s an amazing function for property investors.
So, there you have it, for me it’s interest only mortgages every single day of the week because I know I can make my money back through investing.