A few reasons why IO loans are better than 30 year fixed loans. No, I am not crazy!!

As a REI, you know the power of leverage.  You buy a house by putting a 10% downpayment; two years later, the house value has gone up by 10%.  You have just earned 100% return over two years !!  (Give or take fees and minor details.)  The point here is leverage is king.

So why not leverage more by having a 5% payment and an 7/1 IO loan?  From the leverage point, this sure beats 10% downpayment and 30 year conventional loan.  Because with the same $100k equity you have in your house, instead putting down the down payment for one condo, you can put down the downpayment for 2 condos.  Further, you can have better cashflow of the IO because you are not paying down the principal.

Most people opt for IO loans because they want to live in that big house and can’t afford it.  Younger people (25-30) also get IO loans because they expect their earning to go up substantially and will be able to afford a bigger payment years down the road when their IO period ends and have to pay the principal.

Does this ultra-leveraged investment strategy work today?  Unfortunately no.  :(  There are two reasons.

First because 30 year rates have not gone up despite 13 (or is it 14 already?) rate hikes by the Fed, the difference between 30 year rates and IO rates is relatively small, and thus the advange of having an IO loan is diminished.  Second, in order for this ultra-leveraged strategy to work, you view of the the housing market must be that the it will peak within the next 5-7 years.  Why?  You bought the levereaged property because you want to flip it, but you don’t have to flip it within a month or two.  You can afford to wait, if the IO rate is low enough.

You can think of this strategy similar to buying a call option in real estate.  Essentially, you sit on the property and wait for the market to go up.  When the market goes up *sometime* in the next 5-7 years, you sell.  The downside is that if you have a flat market, your investment has just been locked up for that period.  The worst case is well, the market tanks and you bail out.

When the 30 year interest rates finally begin to rise in the next year or two, and the market bottoms out in the next 3 to four years, you might consider having enough capital saved up to use this strategy to make your big move !!

Your thoughts?