Tomorrow I intend to post some statistical information about what has been happening in our local Wenatchee real estate market.   But, for today I'd like to discuss some posts and comments I've been reading on another blog. JLP at the AllThingsFinancial blog has a couple of recent posts on interest only loans. These loans, I believe, have had a significant role in the current real estate frenzy.

There are many drawbacks of an interest only loan, most of which were discussed in JLP's posts. He mentioned one of the positive things about the interest only loan is that because of the money you save on interest only, you can use the extra money to invest.

The reality is, as JLP pointed out, most people go with the I/O loans because it's the only way they can get into a home (that they really can't afford). In our town of Wenatchee, it's difficult to find a "liveable" place for under $125,000, and interest only loans allow buyers (particularly one income families) to buy more home than they could afford otherwise. The theory, of course, is that your income will go up over time and you will be able to pay more than the interest only, reducing the principal balance. The reality, of course, is that most people pay the minimum amount because, not surprisingly, our expenses almost always meet (or exceed) our income... so we make the minimum payments.

Nevertheless, in my opinion, the advantages of buying a home on an interest only loan ourtweighs the advantages of renting a place to live. Even if you finance with an I/O loan, you are building equity through inflation. Besides, there are some significant tax advantages that simply cannot be ignored.

There are arguments that can be made against this logic, of course... and one of those would be if you can actually rent a nice place to live for less than what your overall expenses of owning a home would be (tax advantages considered). Remember, when you own a home the cost isn't just your mortgages, taxes and insurance. There is also the cost of maintenance and utilities. Eventually you have to paint, replace the roof, replace things... and remodel if you live in a place long enough. As a renter you have no maintenance expenses and, often, some or all of the utilities are covered in the monthly rent. If you really can rent a nice place for less than the cost of buying... then there could be a good argument for investing the extra money somewhere else.

On the positive side, the theory is that even by paying interest only you ARE still building equity in your home. This is through increases in value. For example, let's say values increase a modest 8% per year. 8% is not uncommon on a 20 year average, but far below the current frenzy across the nation. Let's be conservative, just for the sake of a little sanity in an otherwise insane real estate environment.

Anyway, let's say you buy a home for $200,000 and make interest only payments for 3 years. You still owe $200,000, but your home is now worth $248,000... so you have built equity even though you haven't paid down the principal balance on the mortgage. Keep in mind, though, this isn't actually a $48,000 cash-in-your-pocket profit because when you sell a property there are selling expenses. Even if you sell the home yourself without the benefit of a professional real estate agent, your selling expenses will still be 2% - 3% of the selling price, barring any unforeseen repair expenses. That is approximately $4900 - $7400 right off the top. And then, of course, when you purchase a new home (to replace the one you just sold) you'll have buying expenses... probably around 3% of the amount financed. So, now your selling and buying expenses are creeping up toward $15,000. When you sit down and actually look at all the numbers, things don't look so rosy... there's just a lot of money changing hands, which IS a good thing. It's called trickle down economics and makes President Bush very happy!

Anyway... you get the idea. There is another loan that has become popular recently and that is the "cash flow" loan. It is a loan with negative ammortization, meaning you pay less than interest only and the loan amount increases each month. The "cash flow" loan can actually be a good loan option for very disciplined investors... but I'll save that for another time.

Best Regards,
Carol

Disclaimer:   I am NOT an expert in mortgage finance. I am merely expressing my observations and opinions... and serving up a little food for thought.