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The pros and cons of going interest-only

Most people with home loans will agree – the goal is to pay them off as quickly as possible. But for those considering interest-only mortgages, that might not be your top priority.

Interest only home loans are designed with very specific borrowers in mind. It’s a type of home loan where you pay just the interest for a set period.

There are several reasons why you might consider an interest-only home loan – perhaps you’re temporarily down to one income due to a new baby or sickness, you need the spare cash for something else, or you’re a property investor. While lower monthly repayments might seem like an attractive choice, it’s crucial to weigh up the pros and cons of this type of loan before you sign on the dotted line.

Features of interest-only mortgages

An interest-only mortgage is just that – the mortgage repayments you make go towards paying just the interest for a set amount of time. Because your repayments aren’t reducing the principal of your loan, that essentially stays the same.

This type of loan is typically a maximum of five years, after which it reverts to a normal principal-and-interest mortgage.

Interest-only borrowers

Setting up an interest-only mortgage isn’t for everyone. In fact, it’s not suitable for most people – only a select few. Often borrowers will consider this type of loan because they want to pay less each month, but since this means they pay far more in the long run, it won’t suit most home buyers.

The type of borrowers who might choose an interest-only mortgage:

  • Property investors who can claim tax back on the interest paid
  • First home buyers who want to make their first year of loan repayments more affordable after the expense of buying their property
  • Homeowners who plan on selling the property in a few years

Advantages of going interest-only

Interest-only home loans can have some great short-term benefits including:

Potential tax benefits

This is a benefit that can really only be enjoyed by investors, but it’s a benefit, nonetheless. If you’re an investor, you might take on an interest-only loan to free up extra cash to put towards something else, or you know the property value is projected to increase, and you can afford to pay the principal at the end of the term.

With a standard mortgage, paying off your principal and interest at the same time means interest is charged on a smaller total each month. With an interest-only alternative, because the repayments you’re making are interest-only and tax-deductible, you can use this as a tax advantage.

Free up extra cash

Depending on your financial goals, an interest-free mortgage can free up extra cash because you’re not repaying anything towards your principal. Therefore, you can put that money towards other things. Just make sure that money goes towards a financial investment and isn’t wasted on day-to-day living expenses.

The not-so-good things about interest-only mortgages

With the good comes the bad – there are some distinct disadvantages which need consideration before choosing an interest-only loan:

Longer mortgage term

A loan is a loan – there’s no way of getting around that fact. When it comes down to it, you’ll still need to pay off your mortgage in full – and an interest-only mortgage just delays the inevitable.

Unless you’re intending to sell the property in a few years, an interest-only mortgage extends the time it takes to pay off the principal. When it reverts to a standard home loan, your repayments are likely to skyrocket. Make sure you can service a sudden increase in your monthly repayments if you’re considering this type of mortgage.

More interest is paid overall

Interest is an unwanted but necessary part of taking out a mortgage. Don’t forget, you pay interest for the full life of your home loan – not just at the start.

With an interest-only mortgage, because you don’t pay the principal to start with, you end up paying more in interest overall.

Property value drops

In the housing market, there’s never any guarantee your property will increase in value. In fact, it could lose its value, and because you’ve not been paying off any of your principal, you could end up owing more than your house is worth.

Interest rates increase

Currently, interest rates are comparatively low, which means there is no better time to pay off your home loan principal. If rates rise, you’ll want to be paying them on a reduced loan rather than on an untouched principal.

Get expert advice before going ahead

Like any major financial decision, the benefits need to outweigh the risks if you’re considering an interest-only home loan. Whether this type of loan is the right choice for you comes down to your personal circumstances and long-term financial stability.

When considering your options, get professional advice from an experienced mortgage broker. Interest-only loans can be hard to come by – not every lender offers them, even for investors. There are also strict restrictions in New Zealand on interest-only mortgages because of rising house prices and an increase in household debt. You’ll need a mortgage broker’s help to walk you through the application process.

To talk through your options with a mortgage broker, have a chat with the team at Global Finance.