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Contrary to popular belief, debt is not completely evil. In fact, with a well-structured loan, you could use your debt to get rid of it faster!

With the right guidance and financial discipline, borrowers can save a lot of money by opting for an interest-only home loan with an offset account through reduced monthly repayments and sizeable tax benefits.

House and home loan

Principal and Interest (P&I) or Interest-only (IO)?

Before taking out a loan, every borrower needs to decide whether to take a P&I loan or an IO loan. Guided by popular wisdom, more often than not, borrowers opt for a principal and interest loan. In fact, given the current low interest rates, it does make sense to pay back your principal and reduce your debt before the interest rates shoot up in the near future. However, for some investors, as well as owner-occupiers, the additional flexibility that comes with an IO loan could be an effective strategy to adopt.

“Choosing an interest-only loan with an offset account is an effective tax strategy for the financially disciplined borrowers who are particular about regularly making extra repayments into their offset account. Not only do you make smaller repayments and pay lesser interest, but you also maintain better control over your finances,” explains Sam, a mortgage broker at HashChing.

A mortgage offset account is an account linked to your home loan wherein the money held in the account is offset against the outstanding loan and interest is only charged on the remaining amount. The balance in the offset account does not earn interest. Read more.

“With an IO loan, you could do much more with your money than simply pay off debt,” she adds. “For example, if you decide to move to another house as your residence, you could always apply the savings in your offset account towards your home loan that is non-deductible, saving a significant amount of tax.”

“However,” Sam goes on to explain, “an IO loan is not the right option if you are looking to reduce your monthly repayments, as eventually, you would have to pay back the debt. These loans are specifically tailored for investors who could claim tax deductions for the interest paid, buyers who intend to hold on to the property for only a few years before selling it, owner occupiers who plan to use the house as a rental property few years down the line and first home owner who want to make the home loan repayments more affordable for the first few years.”


Are you wondering whether a P&I loan is better for or an Interest Only?

Let us understand the difference with a situation:

A few years ago, Sue and Matt decided to buy their first house. After checking their borrowing capacity and researching the market, they got in touch with a HashChing mortgage broker to understand their options better.

Both were confident that the broker would secure a competitive home loan deal for them, and the couple planned to make additional repayments each year to get rid of the debt faster. However, before they made a decision, the broker also introduced them to the benefits of an interest-only loan with an offset account, so that the couple could make an educated choice.

Lets crunch the numbers

If Sue and Matt borrow $450,000 at a rate of 3.75% (compare home loan deals starting at 3.59% here) over a term of 25 years, and opt for a P&I loan, their monthly repayments would be $2,313.59, and the loan would cost them $694,077.12 over its full term.

Alternately, if the couple opts for an interest-only loan for the first five years, they would be paying only $1,406 monthly for the first five years and a monthly amount of $2,668, thereafter. Over the full term, the latter would cost them $30,617 more than a P&I loan.

But wait, this situation turns around completely if Sue and Matt open an offset account linked to their interest-only loan.

Apart from paying $1,406 each month, the broker advises the couple to save a fixed amount in the offset account each month. The couple evaluates their expenditure and decides they can put $750 in the offset account each month without much strain on their finances. This means, in 5 years, they would save $45,000 in their offset account, bringing their debt down to $405,000 apart from having $45,000 in their account that will save them interest throughout the loan term and also cut off years from the home loan.

Further, the broker informed them if they wished to buy another house as their principal place of residence (PPOR) in the future, they will not be able to redraw on the paid-up portion of their debt and claim tax benefit, unless the amount is used for investment purposes. In case they opt for an IO loan with an offset account, their whole money will be in the offset account, as it would have never actually been used to make any repayments against the loan. Thus, they could use the money to bring down their non-deductible PPOR loan for their new residence by the amount saved in their offset account over the years.

What’s more, with the previous debt restored to the original amount of $450,000, the couple could claim full tax deductions for the interest paid on the loan.

The choice, ultimately, will depend on the size of the loan, the cost of setting up the loan and the reasons for considering interest only repayments over a P&I loan.

Indeed, opting for an IO loan with an offset account could have several benefits, but not for everyone. It makes sense to speak to an expert and understand whether an IO loan is the right choice for your situation or not.

Recently, APRA came down heavily on IO loans, warning the banks to limit IO loans to 30% of their total mortgage lending, and also restrict IO repayments for high Loan-to-Value Ratio (LVR) loans.

In order to keep up with the new guidelines, different banks will implement different measures to stay below the 30% lending limit. Borrowers can expect the following changes:

  • Increased interest rates on IO loans
  • Interest-only repayments only applicable on low LVR loans (less than 80%)
  • Shorter interest-only repayment period

As most economists predict a rate hike in the near future, borrowers who are looking to refinance to a P&I loan from an IO loan, or whose interest-only repayment term is ending, may have trouble in refinancing due to increased monthly repayments. In a recent survey, 57% of the panellists forecasted “thatinterest-only (IO) borrowers would have trouble refinancing.

It is true that borrowers may find it difficult to secure IO loans in the future, but it is not impossible to find a loan with interest-only repayments if it suits your financial strategy. However, keeping in mind the increased costs of setting up an IO loan, it makes sense to revisit your reasons for choosing interest-only repayments and check whether the benefits outweigh the costs. Before you sign the dotted line, it is advisable to get in touch with a mortgage broker to evaluate your finances, and work out an investment strategy by calculating how much you could put into your offset account monthly and whether it is enough to meet your financial goals or not.

At HashChing, we bring you broker pre-negotiated home loan deals from over 60 lenders across Australia, updated every week. Compare home loans online to get the most competitive home loan rates in the market.

 

By Vidhu Bajaj
HashChing Content Writer

 

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