If you’re buying an investment property, or looking for a short-term solution offering lower repayments, you may want to investigate taking out an interest-only home loan.
An interest-only loan is just that – you make interest payments but don’t pay back any of the principal loan amount owing. The catch is that your original mortgage amount is not reduced.
At the end of the interest-free period (usually one to five years) you must start making principal and interest repayments, so you’ll need to make sure your future finances can support this.
Many property investors who specifically buy to build will take out interest-only home loans for a short term period then pay back the principal when they sell the renovated property for a profit. The risk and the hope is that that the property sale price will cover the principal loan amount, the interest-only repayments and the construction costs.
If you buy low and sell high, and keep the renovation costs to a minimum then this is a great way to get financially ahead. Although be aware that if the property is not your principal place of residence then you have to pay tax on any financial gains you make in the process.
The standard home loan
Standard home loans, where the monthly repayment includes paying both the interest and a small portion of the principal, are the most common in Australia. By making at least the minimum repayment over the life of the loan, the principal amount owing will hit zero by the end of the loan term, as this graph illustrates:
Interest only for investment
Interest-only loans were originally designed for those buying an investment property. Because you’re only paying the interest component your monthly repayments will be lower. This gives you greater control over your cash flow, freeing up funds for other investments. There are also potential tax and negative gearing benefits.
For example, on a $350,000 mortgage at 7 per cent interest over 30 years, your monthly repayments would be around $2328. With an interest-only loan your minimum repayment falls to $2041 a month. This frees up $287 a month.
This is probably not a good idea in the long term as it means you’ll never pay off your loan unless you sell the property. Most interest-only loans are only available for one to five years for this reason as this graph illustrates:
When you are looking at holding on to a property for long-term capital gains, better cash flow from rental income may be more important to you than paying down your principal.
Interest only for building
For those building their own home, it may be cost effective to choose an interest-only loan. This frees up cash to pay the rent on your existing residence or for the major outgoing costs of building. Many construction loans offer an interest-free period.
Switching to interest free
If your circumstances change and you wish to switch loans, you may be able to negotiate this with your lender or switch to another lender.
For the traditionalist wanting to live debt free in their own home, forgoing principal repayments for interest only may not be a wise choice. However, with today’s high property prices and low interest rates, an interest-only loan may offer an easy way to enter the property market. If you have stretched yourself financially to buy your home then you may welcome a reprieve from principal and interest payments. An apprentice or trainee on a lower wage may also want to wait to be fully qualified before paying more than minimum interest.
You should get independent financial advice about what is right for your personal circumstances before switching to an interest-free loan.
Taking out an interest-only mortgage can be useful in the right circumstances, but make sure to do your research and be aware of the limitations. It’s best done as part of an overall strategy.