is an interest-only loan a bad idea?

[John Campbell]

Hi everyone,

I have been on the forums for awhile doing research and I feel that it is time to get my first investment property.

I am targeting a duplex in the East Bay and my agent/loan officer has come up with some creative financing ideas that make me a little nervous, but may have merit. I was hoping to post what he is suggesting and get some feedback on whether or not this seems like a good idea.

My agent/loan officer says he can get an interest-only ARM at a 5-7 year introductory period. the numbers we were using worked out to $6000/month interest-only payments. He says that since its interest, we can write off that $6000/month and recover 33% of that based on our tax bracket, so we would get back $2000/month. he said we could request that our employer takes $2000/month less in taxes our of our paychecks, effectively reducing the monthly cost to $4000/month (plus taxes and insurance). we plan to owner-occupy one unit of the duplex and rent the other for at least $2500/month.

Since the interest-only ARM rate adjusts quarterly based on market fluctuations, this could work in our favor as interest rates are expected to come down over the next couple years. We expect the rate to come down a bit over the introductory period of the loan, or worst case scenario, rates would stay the same. I think it is unlikely that the fed will hike rates again.

The strategy would be that when rates come down organically, and before the introductory period of the loan is over, we could refinance into a 30-year fixed PITI loan at a more favorable rate than we can get right now for the same mortgage product. Our long term goal is to BRRRR this duplex. We are hoping to add some equity in the form of renovations and a few years worth of appreciation. Then we want to take a HELOC out against the home. Between the 20% we put down initially, plus equity gained, we are thinking this should be enough money to get into another property. We are hoping that rates come down enough that after we refinance we will be able to move out of the property and hopefully have rents cover PITI payments.

I realize that until we refinance, we wont be gaining any equity in the form of principal reduction, but we are okay with that for a couple years because we would still be gaining some equity in the form of appreciation and renovations.

Does anyone have any comments or feedback about this strategy? Specifically the financing aspect.

Any obvious thing that i am overlooking?

[Andrew Postell]

@John Campbell thanks for the post here.  I would always suggest to trust your instincts on these types of things.  The fact that you went to the internet about this should say something. Now, some basic comments.

Lenders LOVE interest only loans.  Lenders also LOVE variable interest loans.  Both products give lenders BIG profits.  Interest only means you are paying them straight profit without reducing your loan amount.  So, when you do go to refinance (which also makes that lender money) you will then be borrowing the maximum amount again.  They earn money in 4 ways doing this - the initial writing of the loan, all the interest that you pay on the loan, then again when you refinance the loan, and then finally when you are paying on that loan that you just refinanced into.  Maximum profits!  If only all loans could be written this way then every bank's balance sheet would look great!

Now, what about the ARM product? ARMs are the perfect way for a bank to hedge itself against inflation. As rates go up, so does the ARM. As rates go down, so does the arm...but this is also good for the lender too. You see, when you are in an ARM, by default, once it starts adjusting the rate will be slightly below the prevailing market rate. Meaning, when you go to refinance...you will refinance into a HIGHER rate.  This means you are likely to stay in that ARM.  Ok, I know there are instances where the ARM would be higher...but about 85% of the time the ARM is slightly lower.  Remember, this is a product that makes the lender money because they are hedging against inflation.

Now, some things to share about your pay and taxes.  If you pay less taxes through the year...you still have to pay those taxes at the end of the year.  If you pay more in taxes through the year, then sometimes we get a refund (and sometimes you just owe less at the end of the year).  To me, that strategy is highly questionable to justify a loan.  Keep in mind that ALL mortgage interest is tax deductible.  A 30 year, fixed rate loan will also give you tax deductible interest. And to justify paying more in interest so you can write it off...that's flawed logic at every level.

I love it when anyone can use their own primary home to house hack.  That's how I got started.  And I don't really mind when people use some of these alternative products out there...but some lenders are very desperate for business right now.  I hope I'm not coming down too hard on these things but continue to trust that instinct!  

Hope all of that makes sense but do reach out with any additional questions.  Thanks!