Q: I read recently that you are interest only home loans for owner occupiers. I am an owner occupier and I have an interest only loan, but I pay the equivalent of the principal and interest amount each month with the extra money going into my offset account. This lets me still access the cash if I need to, but effectively I am still paying down my mortgage. Why are you against owner occupiers paying interest only, and what are your thoughts on my approach?
A: While there are definitely some pros and cons to interest only home loans, it is my strong belief that debt should be paid down as quickly as possible.
Interest only loans were originally intended for investors because they reduce their loan repayments so the rental income will pay or come closer to paying the mortgage. However more and more owner occupiers are choosing an interest only home loan and this worries me for a number of reasons.
- Interest rates are at their lowest levels in our history, so if you can’t afford to pay down the principal as well as the interest now when rates are this low, how will you manage your repayments when interest rates creep back up again?
- It is far easier to pay down debt while interest rates are low, and the higher the interest rate the more difficult it is to reduce debt. A low interest rate environment is the perfect opportunity for owner occupiers to reduce their debt, because it will only get harder from here.
- Most lenders only offer loans with short interest only periods, generally around five years, so once this ends you will either need to refinance to another interest only loan potentially at a higher interest rate, or begin paying principal and interest.
- When you pay interest only, you aren’t getting any closer to owning your home or building up equity in your home. In the event of a property downturn you may be left more exposed if you need to sell quickly and for a loss.
- Fixing the interest rate on an interest only loan typically isn’t possible, and this can leave you much more exposed to rising interest rates.
Using a home loan calculator, you will see that if you borrow $350,000 over 25 years at 4.8%, for principal and interest your monthly repayments are just over $2,005 a month. After 25 years you have paid just over $251,646 in interest and your $350,000 loan, but you now own your home outright.
If you borrow the same amount for the same term at the same rate but pay interest only, the repayments will be $600 cheaper at $1,400 per month. The only problem is, after 25 years you have paid $420,000 in interest AND you still owe the lender $350,000.
If you are disciplined and your interest only loan allows you to make additional repayments into an offset or redraw facility at no cost to you, then putting what you would be paying as principal into your loan can also help. It will reduce the interest you pay and the principal outstanding, while keeping the money within reach to redraw in case you need it for an emergency. But remember, as soon as you redraw the money your interest and principal loan amount will shoot straight back up.
I have never seen interest rates this low, and that is why I encourage everyone to pay down as much debt as they can now.
If you can afford to make extra repayments and your home loan has the appropriate features, paying off more than your minimum repayment into an offset or redraw account is an option for all owner occupiers to do. If you aren’t sure what home loan features yours has, check with your lender or contact your mortgage broker. Perhaps it’s time to reassess if your home loan is still right for you.
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