Interest only loans: pros and cons
27 Jun 2016

Interest only loans: pros and cons

Interest only loans, a much debated topic, even within the finance industry. Over the years, they have started to become more common with many success and failure stories behind them. Interest only loans are predominantly used by investors for cash flow and tax purposes, however more and more owner occupiers have started to use them. Interest

27 Jun 2016

Interest only loans, a much debated topic, even within the finance industry. Over the years, they have started to become more common with many success and failure stories behind them. Interest only loans are predominantly used by investors for cash flow and tax purposes, however more and more owner occupiers have started to use them.

Interest only loans are where you merely pay back the interest of a loan to the lender – so if you borrowed $500,000 and made repayments for five years, your balance would still be $500,000.

ADVANTAGES OF INTEREST ONLY LOANS

Why would you have one of these loans you may ask? Well to start off with, the repayments naturally are lower as you do not pay the principal back, to give you an example;

Repayments on $500,000 @5% on principal and interest (over 30 years) = $2,685 per month.

Repayments on $500,000 @5% on interest only (over 30 years) = $2,084 per month – a difference of approx. $600 per month.

This saving works well for investors as it usually allows their investment to be self-funding and it gives them flexibility to invest further. Interest only loans can also work for an owner occupier, where although they may not reduce the principal on their home, it does mean they are on the property ladder, not paying rent and hopefully increasing their equity position with rising property prices. If you have a variable rate loan, you can also make overpayments, which naturally reduces the principal.

DISADVANTAGES OF INTEREST ONLY LOANS

The most obvious downfall is that you are never reducing the capital of your loan and potentially not building any equity in your property. Merely paying the interest on your loan means that you would pay more in interest over the duration of the loan, similar to paying the minimum payment on your credit card.

In addition, most lenders only offer interest only loans for a maximum period of five years and then will revert to principal and interest, in which case your repayments will increase significantly.

On this note, with recent changes by regulatory bodies such as APRA, lenders are under increased pressure to tighten up their policies on providing Interest only loans. Some lenders have started to make principal and Interest loans look more attractive by scrapping discounts and asking for higher deposits for interest only loans.

POTENTIAL SOLUTIONS

There are some solutions you should consider prior to taking out an interest only loan. For example, a loan amount more suited to your budget and shopping around for a better mortgage deal. If you decide for an interest only loan, there are features such as an offset/redraw account which can reduce the interest paid on your home loan.

To get further information in regards to interest only loans, contact a local mortgage expert who can help you seek the best solution and lender to suit your current circumstances and future plans.


Raj is a Mortgage and Financial Consultant at Quick Select. You can get in contact with Raj via rajesh@quickselect.com.au.

Leave a comment
More Posts
Comments
Comment
Request call-back
Please provide your name, preferred contact method, and a short message, and we'll be in contact within 4 business hours.