Interest Only vs. 80-15-5

Update: Don’t read this. It’s drivel.

A coworker and I had a long discussion today. He’s buying a house and has been crunching numbers trying to make sure he gets the best deal on his loan. It was a fascinating exercise to try to figure out how the 80-15-5 technique would work with a pair interest only loans.

First, a little background. An interest only loan works like a savings account in reverse. A lender gives you a boatload of money. You pay them interest on that money for an agreed upon period of time. At the end of that period of time you have to give all the money back. To pay down the loan over time you overpay your payment. You are on your own to figure out how much extra to pay. In my loan program, my payment goes down every year as I pay down principal. Cool.

Second, a little more background. Most conventional loans require the borowwer to put down 20% of the loan value in cash. If the borrower doesn’t, that equity has to be insured. Mortgage insurance insures the loan for the benefit of the lender, in case the borrower defaults. The insurance only covers 20-30% of the loan value, but if paid, it increases the odds that the bank will not lose money when the propery is sold following foreclosure. Once the borrower has 20% equity in the home they purchased, the mortage insurance can be removed.

Mortgage insurance isn’t free. It’s paid for by the borowwer. It could easily add $50 a month to a loan payment. So often borrowers will go to extraordinary lengths to avoid having to pay it.

80-15-5 is a plan where a borrower takes out two mortgages on a house. The first is for 80% of the loan. The second is for 15% of the loan; it covers the down payment of the first mortage. The last 5% is the down payment the buyer must pay.

On a 80-15-5 the buyer generally works to pay the second mortage down as quickly as possible.

So a buyer unable or unwilling to put down 20% for a loan can choose to pay for mortgage insurance or a first and second mortgage at the same time. The second mortgage tends to be more expensive, maybe by a couple percent, and will have a shorter term, further increasing the payment.

Throwing interest only loans at the problem makes for some interesting mathematics. Would an interest only loan be best as just a 95% loan + PMI? Or should you go ahead and split it into a first and second mortgage? If you did split the mortgage? What’s the best way to pay it down and pull your payment down?

In an hour we couldn’t figure it all out, but it was an interesting discussion.

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2 Comments on “Interest Only vs. 80-15-5”

  1. Brandon Nolte Says:

    Woot! First post.

  2. Mike Says:

    Wow..dude I’m going through this very thing right now!!! The IO is bad any way you slice it…at least thats how my numbers are crunching… there is some good reading on this upcomming link ….look near the bottom comparison chart comparing he 180K loans, SCARRY!!!!
    http://www.fdic.gov/consumers/consumer/interest-only/index.html


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