It is common for most property buyers to take Principal and Interest loans (PI) for financing their home, but you may be surprised to know that 2 out of every 3 investment loans and 1 out of every 4 owner occupier home loan in Australia are Interest Only (IO) loan!
Yes, it is possible to borrow and pay only interest on your loan (of course, for a limited period of time) and use the spare cash for investing further or meeting other financial obligations. Here is everything you need to know about interest only loans.
1. Lower Repayments – A no brainer, an interest only loan means lower repayments, as you are only repaying the interest. For example, according to our repayment calculator, you make a monthly repayment of $1,583.51 on a $300,000 home loan (for 25 years) at an interest rate of 4%. However, in case you subscribed for an interest only loan, this monthly amount would come down to $1,000. Maintaining an offset mortgage account linked to your home loan can further lower down the repayments.
2. Temporary Relief – Undoubtedly, an interest only loan means lower repayments, but remember the benefit is only for a limited time, as the loan must be repaid at some point in time. In the same example, if you take into account an interest only period of 5 years (and zero fee) – you’d only be paying $1,000 for the first 5 years, but for the remaining life of the loan you’d be making much higher monthly repayments of $1,818.
3. Tax benefits – Borrowers can maximize their tax deductions with an interest only loan. In case you are eligible for tax deductions, by only paying the interest on your loan, you are effectively maximizing your tax deductions by paying interest on a larger amount (because the principle isn’t reducing progressively).
4. Total cost of the loan – While an interest only loan gives much more in terms of flexibility, it also turns out to be more expensive over the life of the loan. In the above example, the total cost of the PI loan turns out to be $475,053 while that of the IO loan comes to $496,306, significantly higher than the PI loan.
5. Flexibility – Undoubtedly, the repayments in the later years may be higher when you opt for an IO loan, but the freed up cash in the interest only period can be used for investing in other things or to pay off other high-interest credit. An IO loan provides a lot of financial flexibility, as there is extra cash on hands that can be used to meet any emergency expenses. However, extra cash also brings in the temptation to spend – only choose this option if you can maintain strict financial discipline.
6. Fees – As with every other thing in life, convenience comes at a cost. Choosing an IO loan isn’t free. You pay a higher interest rate than the average market rate, which may add up significantly to the total cost of the loan. Further, not all lenders offer IO loans narrowing down your choice of products. However, if you feel ‘interest only’ is the right choice for you, Compare weekly home loan deals to get the most competitive rates in the market.
7. Additional Repayments – Having an IO loan doesn’t mean you cannot pay down the principal during the interest only period. Most lenders allow you to make additional repayments at no extra cost and these are adjusted against your principal. So ideally, you get the cake and can eat it too – meaning you are only required to pay the interest but have the option to pay the principle as well in case you find spare cash on hands.
8. No equity if no capital appreciation – Many investors choose an IO loan if they do not intend to hold on to the property for long. While they make minimum repayments, they rely on capital appreciation to build equity in the property. However, in case the property sees no significant capital appreciation, no equity is built into it and it may be difficult to sell or refinance the property in such a situation.
9. A matter of choice – Honestly, only you can decide whether an IO loan is right for you or not. Choosing to only pay interest offers several benefits including financial flexibility and ease of entering the market, however, it is important to consider the equation between benefits and costs before taking any decision.
Interest only loans are popular with investors but also offer several benefits for owner-occupiers as well. In case you are planning a family or predict any extra expenditure for a while, it makes sense to convert to an IO loan to manage your repayments. However, before you make a choice, we recommend you think long and strong and analyze the pros and cons objectively. Speak to one of our mortgage broker to understand your options.
By Vidhu Bajaj