Brendan Burgess
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Interest only mortgages in a falling market?
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Brendan Burgess
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Let's forget the "falling market" bit for the moment and discuss the pros and cons of interest only mortgages.
People buying their first home have very big expenses in the first few years. I recommend that they start with an interest-only mortgage.
A repayment mortgage is a form of saving and people should suspend saving during periods where they have abnormal expenditure e.g. just after buying a house or during maternity leave or unemployment.
I also recommend that the overall strategy should be to get your mortgage down to a comfortable level. In particular, you should do this before you start a pension.
If someone assumes further short term falls in Irish house prices, does the strategy change? Well if you make this assumption, then you should defer buying a house!
If you have bought a house and the price of it has fallen, then getting the mortgage down to a lower Loan to Value is a higher priority than it would otherwise have been.
Brendan
People buying their first home have very big expenses in the first few years. I recommend that they start with an interest-only mortgage.
A repayment mortgage is a form of saving and people should suspend saving during periods where they have abnormal expenditure e.g. just after buying a house or during maternity leave or unemployment.
I also recommend that the overall strategy should be to get your mortgage down to a comfortable level. In particular, you should do this before you start a pension.
If someone assumes further short term falls in Irish house prices, does the strategy change? Well if you make this assumption, then you should defer buying a house!
If you have bought a house and the price of it has fallen, then getting the mortgage down to a lower Loan to Value is a higher priority than it would otherwise have been.
Brendan
I'd be more of the thought that if you can only afford interest payments on a house, you probably can't afford it.
Given that your expenses rise as your wages do (childcare etc), it makes more sense to get to a level you are comfortable with, rather than paying no principal back on a residence, and hoping for better down the line. People always overestimate their future earnings and available cash, and this is what gets people into serious trouble later in life.
No point fooling yourself now into buying a house, hoping that something will happen in the future to make you able to afford payments you are not able to pay anyway.
Credit is not an area one should take chances with.
Also, telling people to hold off pension until father down the line is also not telling the whole story.
Here’s a nice little compounder to illustrate the point.
Person A starts saving at the age of 25. They start out with a zero balance and contribute $200 monthly until retirement (65). Assuming an average annual rate of return of 12%, Person A can retire with $2,061,941.74. Wow! Millionaire status achieved, two-fold.
Person B starts saving at the age of 40. Because person B is further in life, we’ll assume this person started with an initial investment of $10,000 and contributes twice as much, $400 per month, with the same 12% average annual rate of return. Person B will retire at the same age (65) with $886,803.53. Hey, that’s not fair! No, that’s compound interest at it’s finest. J
Interest only mortgages are in general, tools that allow people to think they can afford something they can't.
Given that your expenses rise as your wages do (childcare etc), it makes more sense to get to a level you are comfortable with, rather than paying no principal back on a residence, and hoping for better down the line. People always overestimate their future earnings and available cash, and this is what gets people into serious trouble later in life.
No point fooling yourself now into buying a house, hoping that something will happen in the future to make you able to afford payments you are not able to pay anyway.
Credit is not an area one should take chances with.
Also, telling people to hold off pension until father down the line is also not telling the whole story.
Here’s a nice little compounder to illustrate the point.
Person A starts saving at the age of 25. They start out with a zero balance and contribute $200 monthly until retirement (65). Assuming an average annual rate of return of 12%, Person A can retire with $2,061,941.74. Wow! Millionaire status achieved, two-fold.
Person B starts saving at the age of 40. Because person B is further in life, we’ll assume this person started with an initial investment of $10,000 and contributes twice as much, $400 per month, with the same 12% average annual rate of return. Person B will retire at the same age (65) with $886,803.53. Hey, that’s not fair! No, that’s compound interest at it’s finest. J
Interest only mortgages are in general, tools that allow people to think they can afford something they can't.
Brendan Burgess
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The pension point is frequently made but is invalid. Of course, you have more if you start a pension early if you compare starting a pension with wasting the money. If you redo your figures to show someone who saves through buying a house instead of saving through a pension scheme, you will in many cases show the house buyer better off.
So you would advocate someone to enter a financial agreement where they buy something that they don't/can't actually pay for, but service the loan just to get their foot in the door.
Then, if necessary, ignore pension contributions while doing so if necessary?
Sounds like a recipe for financial disaster to me.
And ruling it "invalid" without showing how doesn't strike me as good advice.
What if that person instead of getting in over their heads at such a young age, ask themselves what house they can realistically afford payments on, along side contributing to their pension.
That would be what a responsible person would do. You don't put all your eggs in one basket, and people should realise that their financial future encompasses more than just a mortgage.
I can think of no financial advisor anywhere who would advocate ignoring the real issue of retirement savings for the sake of getting on board with an interest only mortgage.
A person who finds themselves in this situation should take a good hard look at their financial goals in life.
When did wasting money come into the arguement here? An interst only mortgage could be considered by many to be "wasting money", since you are gaining nothing from money you are spending. Responsible financial planning requires broader goals than just getting a roof over your head at any cost.
Then, if necessary, ignore pension contributions while doing so if necessary?
Sounds like a recipe for financial disaster to me.
And ruling it "invalid" without showing how doesn't strike me as good advice.
What if that person instead of getting in over their heads at such a young age, ask themselves what house they can realistically afford payments on, along side contributing to their pension.
That would be what a responsible person would do. You don't put all your eggs in one basket, and people should realise that their financial future encompasses more than just a mortgage.
I can think of no financial advisor anywhere who would advocate ignoring the real issue of retirement savings for the sake of getting on board with an interest only mortgage.
A person who finds themselves in this situation should take a good hard look at their financial goals in life.
When did wasting money come into the arguement here? An interst only mortgage could be considered by many to be "wasting money", since you are gaining nothing from money you are spending. Responsible financial planning requires broader goals than just getting a roof over your head at any cost.
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cancan
I was simply showing how that "you should start a pension early" point was invalid. You should start saving early. But saving through a pension scheme is not a good idea until someone has bought their house. Pension salesmen make the same invalid comparison, time after time.
As it's very expensive to trade up after a few years, it makes huge financial sense to put all your money into buying a house and deferring a pension. You get more of a house earlier and you may save yourself one rung of the ladder.
This argument comes from the "rent is dead money" school of thought. Interest is the cost of renting money. You are getting the use of money to buy your house. You can live in the house. So, in effect, the interest is the cost of getting to live in a house.
Brendan
I was simply showing how that "you should start a pension early" point was invalid. You should start saving early. But saving through a pension scheme is not a good idea until someone has bought their house. Pension salesmen make the same invalid comparison, time after time.
As it's very expensive to trade up after a few years, it makes huge financial sense to put all your money into buying a house and deferring a pension. You get more of a house earlier and you may save yourself one rung of the ladder.
This argument comes from the "rent is dead money" school of thought. Interest is the cost of renting money. You are getting the use of money to buy your house. You can live in the house. So, in effect, the interest is the cost of getting to live in a house.
Brendan
Why would someone pay more to rent from the bank rather than renting from a landlord? Particularly with the stamp duty changes which means that FTBs would be well advised to avoid purchasing on the "first rung" as you call it.
I still don't see why the goal should not be to have savings, pension, and housing as three distinct strands of the financial goals of anyone starting out in the world these days. They are three seperate entities to solve three very distinct problems, and one should not be used as a substitute for another.
Putting all your eggs in the housing basket is both irresponsible and naive for a young person to do - In a worst case senario, loosing your house would mean you loose everything, whereas any money contributed towards a pension, or other investment vehicle, is locked away, allowing a more secure future.
With the current stamp duty rates and the expense of furnishing etc a house, why bother getting on the "ladder" in the first place, if your goal is to trade up down the line. Saving until you have enough wages or savings to mach your home purchasing goals would make a lot more sence.
What does one actually get out of an interest only mortgage, that one would not get renting the same property?
I have no problem with people getting a mortgage and paying back for the house they want, but this interest only renting from the bank lark is a stupid way for someone to put themselves into a home.
Again, if you can't afford to make proper repayments on your current wages, you probably should be lowing your expectations, and not your chances of a decent retirement and proper financial future.
Brendan Burgess
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Absolutely disagree with you on this. You must take an overall approach to your finances. They are all part of the same long term plan. They are all forms of savings with different characteristics. The big downside of pensions is that they cannot be accessed for 40 years. That is no good to someone who is having a problem paying their mortgage.
Again this is a false argument. Most of us would agree that buying a house is a good long term financial plan. Even if you expect house prices to fall, you should be saving with a view to getting into the market when it is fairly priced. You have no choice but to buy one house. You can't buy a share in 5 different houses. It's a false metaphor.
There is some sense in this point. Most people trade up a few times. The FTB's exemption does encourage people to hold off as long as possible with a view to buying on the second rung of the ladder so to speak.
However, if a couple is committed to buying a home, then they should try to buy as big a home as possible to avoid the cost of having to trade up too soon. This does come at the risk of overborrowing, but it's probably worth that risk. That is a decision that they have to make for themselves.
It's important to note that buying a home gives more than financial benefits.
When you're sensible in money and life it's easy to assume everyone else is. This is rarely the case. The number 1 criteria for the majority of FTBs when geting a mortgage from a broker isn't lowest interest rate or customer service (these are sensible things), it's who will give me the most money.
First time buyers like payment holidays, discounted interest rates, 100% mortgages, if they didn't these products wouldn't exist. In reality these products allow you to buy a property sooner with less savings for a higher amount.
The only advantage to going interest only when getting a mortgage is if property prices are rising, the extra risk you have taken is then rewarded by buying sooner rather than waiting till you have enough savings, high enough wages, a stable relationship - sensible things - by which time prices have risen and "you'll never be able to afford to buy".
However many people will use these products out of desperation, greed or poor judgement.
First time buyers like payment holidays, discounted interest rates, 100% mortgages, if they didn't these products wouldn't exist. In reality these products allow you to buy a property sooner with less savings for a higher amount.
The only advantage to going interest only when getting a mortgage is if property prices are rising, the extra risk you have taken is then rewarded by buying sooner rather than waiting till you have enough savings, high enough wages, a stable relationship - sensible things - by which time prices have risen and "you'll never be able to afford to buy".
However many people will use these products out of desperation, greed or poor judgement.
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Not at all. I don't think that the two issues are connected very much at all.
When you buy a house, you do not know if house prices are going to rise or fall in the short term.
Paying interest only, means that you have more money with which to adjust to the life of home ownership. If you are in the housing market for the long term, which most people are, then what happens in the short-term to prices is not very relevant.
Brendan
For you maybe. But many people use IO inappropriately. When thery're giving IO mortgages there isn't a guy on the door going "ok, you're a smart sensible chap here's an IO mortgage. Oh sorry love you're a bit of a dullard LTV of 80% for you".
You don't have to go very far to find stories of people getting way over their heads with debt, the site is full of them - many simply from the pain of having to adjust from a discounted mortgage rate to a full one. The main criteria for a bank in determining whether to give a mortgage is the part of the form that lists your wage, and when you've full employment in a state you can be sure that there are a lot of financially naive people earning good wages. The human element just isn't there. When you have accumulated savings over a prolonged period of time you demonstrate an ability to make financial commitments. A sensible person may indeed use an IO mortgage to adjust, a very sensible person would have saved for a number of years at the same rate of a full mortgage to demonstrate their ability to repay the loan and reduce the amount eventualy borrowed.
But in a rapidly rising market saving is a luxury those desperate to get on the ladder cannot afford. Interest only mortgages have been used by brokers in the last few years as a mechanism to keep an applicants repayments below 40/45% of their take home pay. I wouldn't be financially naive enough to go down that route, you probably wouldn't be either but that's not to say many others aren't. If you don't understand a financial product the given advice is to not invest in it. I've seen enough threads with "I've a mortgage of X paying Y a month, if I go interest only what will my repayments be?" in them to see that many people don't understand even relatively simple products like this but are fully prepared to use them as a means to an end - buying the most expensive property they can today.
Forget rising or falling markets with regard to IO mortgages.
They are a bad idea full stop, regardless of what the market is doing.
You are taking money off someone, which you are not paying back, and are paying for the privilege of having it. I can think of few instances where doing this is a good idea, no matter what the market is doing.
You're average borrower has no idea if prices will be up or down two years from now, so it should not even be a consideration, or reasoning for taking one out, or used in the logic for justifying it or not.
And what happens when your payments reset after your allotted time period and you're finances are not in as good shape as you hoped they would be (Again, people always assume they'll be on more that the are in reality.)
There are very sound principals to borrowing money which have been established for a long time, and people should heed them.
You don't get something for nothing, and people should exercise some more prudency when it comes to matching their aspirations with their reality.
Granted you'll no doubt hear of cases were people fluked market timing, just as you'll hear stories of people who got hurt with IO mortgages. Are you willing to bet your financial future on a 50/50 shot?
Again, if you can't afford to pay it back properly, you can't afford it full stop
They are a bad idea full stop, regardless of what the market is doing.
You are taking money off someone, which you are not paying back, and are paying for the privilege of having it. I can think of few instances where doing this is a good idea, no matter what the market is doing.
You're average borrower has no idea if prices will be up or down two years from now, so it should not even be a consideration, or reasoning for taking one out, or used in the logic for justifying it or not.
And what happens when your payments reset after your allotted time period and you're finances are not in as good shape as you hoped they would be (Again, people always assume they'll be on more that the are in reality.)
There are very sound principals to borrowing money which have been established for a long time, and people should heed them.
You don't get something for nothing, and people should exercise some more prudency when it comes to matching their aspirations with their reality.
Granted you'll no doubt hear of cases were people fluked market timing, just as you'll hear stories of people who got hurt with IO mortgages. Are you willing to bet your financial future on a 50/50 shot?
Putting everything you have into one asset on an interest only basis is not a financial plan. It's a high risk undiversified bet, and people should look at the whole picture before running down the garden path.
Again, if you can't afford to pay it back properly, you can't afford it full stop
It's simple. If you're not paying back even a small amount of the capital, you're just rolling over the loan (same as renting, except sometimes more expensive). Why would you bother? Just wait till you can afford to buy, surely? Or just rent. There's no proven economic "fact" that buying is better than renting anyway, despite what many of us think. The psychological value of owning versus renting is very difficult to quantify in monetary terms.
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Howitzer and CanCan
Your objections to interest-only seem to be on the grounds of over-borrowing? Howitzer, you seem to be confusing interest-only with 100% mortgages in the same sentence?
And Howitzer, you make a valid point about sound financial common-sense might apply to you and to me, but not to others.
And I have been shocked by some stories on Askaboutmoney from people who have clearly overborrowed. But I guess that 90% of borrowers are well able to meet their repayments. For those, interest-only in the first few years of their mortgage makes sense. They don't have to blow the repayments saved on new cars and drink. They can use it to improve their home. They can even save it elsewhere to rebuild a savings fund.
Cancan said
I can think of quite a few...
If you are buying an investment property, you should have an interest-only mortgage.
If you have suffered a sudden reduction in income due to unemployment, illness or starting a business, you should have an interest-only mortgage.
If you have a mortgage at a very comfortable level in relation to your income and the value of your home, you should consider switching to interest-only and use the repayments saved to invest in your pension.
If you are elderly and own your own home but have a limited income, then you can take out a life-loan which is an extreme version of an interest-only loan.
There is an old-fashioned idea that mortgages should be paid over 20 years and people should start contributing to a pension at age 21. These ideas need to be challenged and reviewed from time to time.
Brendan
Your objections to interest-only seem to be on the grounds of over-borrowing? Howitzer, you seem to be confusing interest-only with 100% mortgages in the same sentence?
And Howitzer, you make a valid point about sound financial common-sense might apply to you and to me, but not to others.
And I have been shocked by some stories on Askaboutmoney from people who have clearly overborrowed. But I guess that 90% of borrowers are well able to meet their repayments. For those, interest-only in the first few years of their mortgage makes sense. They don't have to blow the repayments saved on new cars and drink. They can use it to improve their home. They can even save it elsewhere to rebuild a savings fund.
Cancan said
I can think of quite a few...
If you are buying an investment property, you should have an interest-only mortgage.
If you have suffered a sudden reduction in income due to unemployment, illness or starting a business, you should have an interest-only mortgage.
If you have a mortgage at a very comfortable level in relation to your income and the value of your home, you should consider switching to interest-only and use the repayments saved to invest in your pension.
If you are elderly and own your own home but have a limited income, then you can take out a life-loan which is an extreme version of an interest-only loan.
There is an old-fashioned idea that mortgages should be paid over 20 years and people should start contributing to a pension at age 21. These ideas need to be challenged and reviewed from time to time.
Brendan
LDFerguson
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In an ideal world, everyone should start contributions towards a pension AND regular savings once they get their very first pay-cheque. But only a minority are so prudent, in my experience. So if you're not one of that minority and can only afford to do one or the other, I'd concentrate on saving towards a house before starting a pension, as you will need a house long before you will need a pension.
Howitzer made a very good point above:
Interest-only for First Time Buyers falls into the same category. Again, if everyone was prudent there would be no demand for these facilities. No First Time Buyer would buy a house until they had saved a 10% deposit plus expenses plus enough money to buy furniture, cleared off any other loans and would qualify for an annuity mortgage that would cost them less than 30% of take-home pay, even after stress-testing by increasing interest rates by a percent or two.
But this isn't your average First Time Buyer, as everyone knows. So what should lenders do? Withdraw all products that allow an "easy start" in one form or another?
Howitzer made a very good point above:
Interest-only for First Time Buyers falls into the same category. Again, if everyone was prudent there would be no demand for these facilities. No First Time Buyer would buy a house until they had saved a 10% deposit plus expenses plus enough money to buy furniture, cleared off any other loans and would qualify for an annuity mortgage that would cost them less than 30% of take-home pay, even after stress-testing by increasing interest rates by a percent or two.
But this isn't your average First Time Buyer, as everyone knows. So what should lenders do? Withdraw all products that allow an "easy start" in one form or another?
Compund interest is all well and good but you also have to consider the rate of inflation over the term of the pension fund.
Take inflation at 4% p.a.
the 2m the the 25y.o. has built up in a fund will only be worth about 632K in real money terms when taken into account from the time they start saving
The 886K that the 45 y.o. has build up in a fund would be worth about 425K in real money terms when taken into account from the time they start saving.
Not such a big difference in the fund value as your example.
cancan said:
Maybe I'm being short sighted, but it's all very well having a secure future, but it shouldn't be at the expense at a secure present. You can have both, it's a case of priorizing those needs.
I did buy a house before I started paying into a pension fund. I bought a house in my late 20s, started a pension fund in my early thirties.
Brendan Burgess
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Blinder
That's a great quote. I hope you don't mind me plagiarizing it?
Brendan
That's a great quote. I hope you don't mind me plagiarizing it?
Brendan
I knew that's how it sounded even as I typed. But yes you're right, my fundamental objection is based on overborrowing. IO has been used as a mechanism to allow FTBs to borrow more than they would have on a conventional mortgage.
Whilst it's up to the individual to make their own decisions in life Financial Regulators are there for a reason, in the case of the Mortgage market it's to prevent products and practices that are overtly risky. But as soon as the Regulator moves in one direction Brokers and Banks find ways to keep their income as high as possible by giving the biggest possible mortgages (why wouldn't they, it's their business).
I've said it before but to me your advocation of IO seems more a case of youth is wasted on the young and ignores the reality of the last 4 years or so when many many people have overextended themselves.
There is a subtle difference between someone getting an IO mortgage to buy a property and someone making their mortgage IO for a short period of time.
Sorry to be a bit simplistic here compared to some of the great detailed replies above but isn't it a case that a major cause of the sub-prime defaults in the US (and here) were caused by lenders lending too much money to people who couldn't afford to repay.
These effectively were/are interest only mortgages (with a high rate) and the pain caused to borrowers hit home when the interest only term lapsed and the mortgage reverted to "regular" payments.
What is suggested in other posts sounds strikingly similar, although and to be fair the banks here so not have the same rates and are not as preditiory but however the same system is at work. How could this be prudent for a FTB to use IO based on future earnings and hope that in 3/5 years their wage has matched their expectations (in a recession...?) and they can afford to start paying off the principle.
Again, if you can't afford to pay it back properly, you can't afford it full stop
This is the way banks and borrowers should be looking at a mortgage, not how much can i possibly wedge out fo the Bank in the short term and hope/bet that everything else falls into place.....
These effectively were/are interest only mortgages (with a high rate) and the pain caused to borrowers hit home when the interest only term lapsed and the mortgage reverted to "regular" payments.
What is suggested in other posts sounds strikingly similar, although and to be fair the banks here so not have the same rates and are not as preditiory but however the same system is at work. How could this be prudent for a FTB to use IO based on future earnings and hope that in 3/5 years their wage has matched their expectations (in a recession...?) and they can afford to start paying off the principle.
Again, if you can't afford to pay it back properly, you can't afford it full stop
This is the way banks and borrowers should be looking at a mortgage, not how much can i possibly wedge out fo the Bank in the short term and hope/bet that everything else falls into place.....