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    A very Important guide from Global Finance

    The phrase “interest-only mortgage” is actually a misnomer because it’s not an interest-only mortgage, it’s an interest-only period. Interest only mortgages still need to be paid off at some point reduce the principal.

    Interest-only home loans can be a strategic financial move, but it is a very good idea to be fully aware of the ramifications before taking one out. With help from Aseem Agarwal, Head of Mortgages at Global Finance in New Zealand, we looked at some of the issues surrounding interest-only mortgages and how they affect both investment property owners and home owner-occupiers.

    We look at the trade-offs involved in taking out an interest-only mortgage and Aseem provides practical advice to help you to make an informed decision.

    What is an interest-only mortgage?

    An interest-only mortgage is just that: all repayments go towards paying just the interest. Repayments do not reduce the principal of your loan. Going interest-only helps reduce the monthly payments but it also brings with it other considerations.

    Owner-occupied interest-only loans

    For owner-occupied properties, banks will grant interest-only mortgages during financial hardships, such as job loss or health issues. Aseem Agarwal underlines that while initial support is provided, there’s a limit to extending interest-only periods. Some lenders do allow interest only for owner occupied houses for an initial period two years only.

    To initiate the process, you need to make a formal application demonstrating your ability to service interest-only repayments. If the bank doesn’t approve the loan, you can apply to the bank’s financial well-being or hardship team. They may approve an interest-only loan for 3 to 6 months at the first instance.

    After the initial period, the bank will re-evaluate your situation. If your position has improved, you might be required to resume principal and interest payments. However, if challenges persist, selling the property to settle the loan or re-entering the market after improvement could be suggested.

    Aseem Agarwal emphasises that banks aim to assist customers in the short term but will avoid placing clients under prolonged financial hardship.

    Investment properties and interest-only mortgages

    The maximum period banks will loan interest-only to investors, generally it is five years. On many rental properties, the rental income only covers barely interest portion of a mortgage. An interest-only mortgage can be a strategic move for those investors eyeing capital gain when selling the property and want to put unnecessary burden on cash flow.

    Principal reduction and long-term costs

    Taking out an interest-only loan will provide short-term cash flow and minor income tax relief. However, over the longer term, it results in higher future repayments as the principal doesn’t decrease during the interest-only phase. This has major financial consequences as the cumulative interest paid over the loan’s lifetime tends to be higher because it takes longer to

    Why opt for interest-only on investment properties?

    Aseem identifies two primary reasons investors opt for interest-only loans: cash flow and tax advantages.

    Firstly, an interest-only mortgage can help with cash flow. Keeping the repayments on investment property loans as low as possible frees up extra cash, allowing investors to focus on paying off their primary residence mortgage faster or paying off high-interest rates loans such as personal loans, car loans, or outstanding credit card balances first.

    Secondly, there have been tax advantages. The cost of interest on a mortgage can be tax deductible. It can be used to offset rental property income, so investors pay less tax.

    Assem explained this further by pointing out that as the interest paid on the home loan is a claimable tax deduction as per IRD rules , then paying interest-only maximises that deduction. Paying off the principal as well would mean that interest is charged on a lesser loan amount, which in turn reduces the amount of the tax deduction on interest expenses.
    These rental property interest deductibility rules are expected to be reinstated in due course of time in New Zealand.

    Another reason for taking out an interest-only loan might be that you are looking at a bridging loan between purchasing one home and selling another.

    Calculating the true cost

    Aseem emphasises the need for a calculated approach to taking out interest-only mortgages. During the interest-only phase, your principal won’t decrease, resulting in higher instalments later. For example, if you have a 30-year mortgage and choose to take five years interest-only, the remaining loan term would be over 25 years. Let’s break that down further.

    • An $800,000 loan at 7.5% over 30 years, principal and interest (P+I), has monthly repayments of $5,5594. The total interest paid over 30 years is $1,213840.00

    Imagine you take out an interest-only mortgage for 5 years, the maximum period for which banks will loan.

    • An $800,000.00 loan on 7.5% over five years, interest-only, has monthly repayments of still be $5000. The total interest cost over five years will be $300,000.
    • A $800,000.00 loan on 7.5% over 25 years, principal and interest, has monthly repayments of $5912. The total interest over 30 years will be $1273600.00.

    Take out an interest-only period on your mortgage for five years and you will end up paying $1,273600.00 in interest over 30 years, which is higher than you would for a standard P+I mortgage by $59760.00. Additionally, repayments over the remaining 25 years would be over $318.00 more each month because you have a shorter time in which to repay the loan. This could be difficult to manage sometimes.

    Tax considerations and the conundrum

    Investors should also weigh the immediate tax and cash flow benefits against the long-term costs of interest-only periods. Minor Tax advantages make running losses on rental properties appealing but Aseem explains that investors often overlook the long-term impact, only focusing on the short-term gains: the tax refunds which is also minor amount. Off course a smaller payment is there in the short term but at an extra cost of $59,760.00 extra interest paid.

    “What people often don’t do the calculations on is the following: I’m getting X amount of tax refund by running a higher loss, but by having to pay interest costs for an additional year to the bank, how much more am I paying in interest? Does that interest cost that I’ve paid extra to the bank outweigh the tax refund I got? And that’s the big question. That’s the conundrum that most people don’t actually think about”.

    Moving property values

    Another risk with interest-only loans is if your property loses value while you are not repaying any of the principal, then you could end up owing more than it is worth. This may mean you end up selling the property for a loss.

    The cost over time consideration

    Over the long term, interest-only loans can be more expensive. Aseem has highlighted that while immediate gains might seem attractive, the ultimate cost needs careful consideration. Unless there is a valid reason to choose an interest-only loan, you could just be delaying – at your own cost – the inevitable. All interest-only mortgages need to be paid off at some point.

    Is an interest-only mortgage the right option for you?

    When it comes to the question of whether you should take out an interest-only home loan, you need to be very clear on the rules, benefits, and potential pitfalls. Global Finance provides personalised guidance and support to you .

    Whatever your reason for looking at this option, sitting down with one of their qualified financial advisers will help understand all the pros and cons as they pertain to your unique set of circumstances. Ultimately, you want to be certain that whatever your choice, you’re doing the right thing by your finances. Thinking of going interest-only? Talk to the Global Finance team today at 09 255 5500 or info@globalfinance.co.nz.

    The information and articles published are true to the best of the Global Finance Services Ltd knowledge. Since the information provided in this blog is of general nature and is not intended to be personalized financial advice. We encourage you to seek Financial advice which is personalized depending on your needs, goals, and circumstances before making any financial decision. No person or persons who rely directly or indirectly upon information contained in this article may hold Global Financial Services Ltd or its employees liable.