Q. I’m looking to refinance. My house is valued at $400k, and my loan balance is $155k. I’ve heard about interest only loans but I don’t really know what they are or how they work. Can you explain them to me and whether it’s a suitable option?
A. Interest only mortgages involve you only paying the interest on your loan for a specified period, and not the principal loan amount. Standard home loans typically include paying both the interest and a small amount of the principal loan in each repayment.
Interest only loans were originally intended for investors as it reduces their loan repayments so the rental income will pay or come closer to paying the mortgage. This gives greater control over cash flow and potentially frees up funds for other investments. However, they are now becoming more popular with owner-occupiers who want or need to reduce their mortgage repayments for a period of time.
While I don’t know if your property is an investment or your home, I will assume that it’s your principal place of residence in this scenario. I’ve outlined some of the advantages and disadvantages of interest only loans, including a very important tip which could help reduce the term and total amount of your loan.
Advantages of interest only loans
Interest only loans reduce your minimum repayments because you only pay off the interest and not the principal loan. This can help if your budget tightens or you want to use the money for other things, such as paying for a renovation, saving for another property or other major cost;
If you don’t need the money saved for something else, putting that money into something with a higher return than the interest rate on your mortgage may make that money work harder for you;
Many interest only loans offer the same features of standard loans with the added benefit of lower repayments for the interest only period; and
If you’re going to come into some money in the near future and buy a more expensive property, instead of buying something cheaper and then upgrading when you get your windfall, you could make the loan interest only and buy the more expensive property now. This will also save you other costs that come with buying, selling and moving homes. Just make sure that money is a sure thing so you don’t find yourself unable to pay your loan when the interest only period expires.
TIP! If you’re disciplined, an interest only loan can also save you time and money off your mortgage. If your budget is tight you can stick to the lower interest only repayment, but if your loan allows you to make additional repayments or you have an offset or redraw facility, putting the saved amount into your loan will help you reduce the interest paid and your principal too.
Disadvantages of interest only loans
Because you’re only paying off interest, your original loan amount doesn’t reduce because you’re not paying any of it back;
Interest only loans for owner-occupiers are not a long-term option and many lenders only offer loans with short interest only periods, generally around five years, so don’t bank on using an interest only loan to pay for life’s basic essentials;
When the interest-free period ends, you’ll then need to repay interest and a principle component of the original loan, so make sure this will be affordable;
Interest rates on interest only loans typically can’t be fixed, so you’re vulnerable to rising rates;
If property prices fall and you need to sell, you may end up selling for a loss possibly leaving you with a balance to pay; and
Don’t let an interest only option lull you into a false sense of security – make sure you can afford your loan when principal and interest is charged otherwise you may be stretching yourself beyond your means.
Notwithstanding the possible benefits of an interest only loan to some home owners, I’m personally not a big fan. I firmly believe home owners or owner occupiers are far better off reducing the loan amount as soon as they can. Building up equity in your home provides added security and can act as a buffer in the event of any property downturn.
You should get independent financial advice before switching to an interest-free loan. I also recommend you speak to an accredited mortgage broker for free home loan advice specific to your circumstances. They will be able to compare loans from different lenders to find one suited to you, including those that offer an interest only option if you decide this is right for you.
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