Are you shopping for a home loan? One option open to anyone interested in taking out a property loan is an interest only home loan, where the borrower is liable for interest payments for the duration of the loan and is then liable for repayment of the principal sum in full at the end of the term.
If you are curious about this loan type and how you can apply, we have all the details you need here.
And before we start, here's a little disclaimer. Information provided on this article is for reference only. It does not constitute to professional financial advice. 😀
Interest Only Loan Definition
This type of loan is a great option for people who are looking for lower repayment terms.
With an interest only home loan, you will only need to pay the interest for the duration of the term. The repayment of the principal amount is deferred to the end of the term. This differs from a traditional loan, where the borrower needs to make repayments of both the principal amount and the interest. The terms of an interest only mortgage are more flexible and can be useful for investors who buy and sell properties and for those individuals strapped for cash.
Lower interest payments can make it easier for people to purchase a property, but it is important to remember that although the repayments will be lower, the borrower will need to plan ahead in order to be able to repay the principle sum at the end of the term. Interest only loans have a high default rate when the term expires as some borrowers find it hard to repay the principal amount at the end of the term. Once the interest only term comes to an end, repayments can increase significantly and can, without careful planning, led to financial difficulties and bad credits. For these reasons, there are strict guidelines in place that regulate this type of loan and it is common for interest rates to be higher than regular loans.
Interest Only Home Loans – How it Works
If you need money and are able to use your property as collateral, a loan can sound like a brilliant idea. With an interest only loan, borrowers can take advantage of lower repayments for an agreed period, so this type of loan can help alleviate financial pressures. With an interest only loan, the borrower will be able to make lower repayments for the agreed period.
For example, if you borrow $100,000 with a 30-year term at an interest rate of 6 percent, the monthly repayment on a traditional loan with interest and principal repayments would be $599.55. However, if you opt for an interest only home loan at the same rate, repayments would be $500, saving you around 17 percent or $99.55 with an interest only loan.
The main target consumers for this type of loan are property investors, but they can be helpful for owner-occupants too.
One concern when taking out an interest only loan is the small progress made by interest only repayments which pay for the interest on the loan only but do not bring down the principal amount. However, these loans also allow the borrower to make voluntary payments to reduce the principal amount. This way, the amount owed at the end of the loan term can be reduced.
Another difference with an interest only loan is the term. The usual term for these loans is just five years, whereas other home loans can last for as long as 30 years.
Reducing Interest with Offset Accounts
One strategy to make the most of an interest only loan is to maintain an offset account linked to the loan. An offset account is similar to a transaction account, but it has the added benefit of reducing your loan’s principal sum.
An offset account acts as a safety net for creditors should your financial situation change in the future. Let’s use the same example as above where you borrow $100,000 at 6 percent interest. For a regular interest only loan, you would have to pay $500 for the monthly interest.
Now, let’s assume you have an offset account where you have deposited $10,000. In this scenario, the interest computation will be based on a principal amount of $90,000 instead of $100,000. Instead of paying $500, you will only have to pay $450.
Having an offset account will decrease the monthly payments which will provide you with greater leverage over your funds. It is important to consult a mortgage broker or financial planner before deciding which option is best for you and to consider the tax consequences of your options.
Interest Only Mortgage: The Pros and Cons
Why do some people choose interest only loans? Here are some of the benefits of this kind of loan.
It allows you to buy a higher value property.
When you take out a loan, creditors will look into your debt to income ratio to assess your eligibility. With an interest only loan, the amount you can borrow increases, enabling you to afford a more expensive property. It is important to weigh up the risks of this option and ensure that you will be able to pay the principal amount borrowed at the end of the interest only term.
It frees up more cash.
Lower interest payments mean lower cash outlay for you so that you can use your money to invest elsewhere.
Maximum tax deduction.
There’s a reason why investors love interest only loans, and the answer lies with tax deductions. The interest on these loans is tax deductible which means that the total tax payable decreases.
While lower cash payments are attractive, interest only loans have drawbacks too. Here are some of them.
You don’t build equity in your home.
Based on the design of an interest only loan, you won’t build equity in your home, since you are paying only the interest on the amount rather than reducing the amount that you borrowed.
Increased underwater risk
By paying off only the interest portion of the loan, the amount you owe for the property remains the same. If the value of the property decreases, you will still be liable to repay the full amount, leaving you with a shortfall.
Higher cash out for paying off the loan
For traditional loans, you have to make uniform payments. For an interest only loan, you need to pay the principal amount in full at the end of the term. In the example used above, by the end of the 30-year term, you will have to pay $100,000 in full.
Choosing an interest only loan does not avoid the principal payment but defers it to the end of the term. If you are unable to repay the full principal amount at the end of the term, then you may be in danger of losing your property.
Interest Only Home Rates in Melbourne, Australia
Looking for interest only loans with reasonable rates can be tough. However, there are still facilities offering reasonable rates for this type of loan.
Some companies offer a variable rate of 3.89 percent per annum while the comparison rate is at 3.92 percent. Some providers advertise rates as low as 3.69 percent.
For people looking for the best rates, it is beneficial to consult a mortgage broker to help you navigate the process. These professionals can help you find the best deal after assessing your individual financial circumstances.
Should I Go Interest Only on My Home Loan Temporarily?
People take out interest only home loans for various different reasons. Here are some reasons borrowers choose to take out this type of loan.
Pay Off Outstanding Loans
Interest from personal loans and credit card debt can add up - this will cost you a lot of cash in the long run. Consolidating all these debts into one loan can be beneficial and can help you to manage your finances.
Some people take out an interest only loan with the sole intention of investing their money in shares or other funds.
This can be a risky move, especially if you are not a professional investor. Stocks and shares can be volatile, and a downturn could leave you without the initial investment as well as the extra responsibility of having a loan to pay off. This strategy is not advisable for those who really can’t afford to lose their initial investment.
Redirect Cash Funds into More Immediate Needs
Unexpected events such as illness can be costly. Interest only loans might be a way to free up some of your funds in order to cover any unexpected costs which can cause financial strains when you also have the burden of a house loan. With an interest only loan you can lower your payments and revert to paying off the principal amount once your financial situation has improved.
Why Go Interest Only?
Buying a new property is a big decision - and also an expensive one. Having a sound financial strategy can help you ensure that the process runs smoothly.
Here’s a quick snapshot of what an interest only loan has to offer.
- 100% offset. Borrowers only need to pay off the interest portion of the loan. However, they do have the option to pay funds into an offset account. This way, interest payments will decrease, meaning that the borrower can set aside funds to pay the principal amount at the end of the term.
- No Redraw fees. What if you need to borrow money after repaying a portion of the loan? Many interest only loans do not charge a fee for this, since the borrower is only obliged to pay the loan in full at the end of the period. Always check with your lending provider if they plan to waive this fee for the loan products they offer.
- Variable and lump sum repayments. At any time within the loan term, you might find yourself having extra disposable income. With a flexible interest only loan, there are no restrictions on how much of your principal you repay, meaning that you can lower the principal amount by making additional payments when you are able.
Applying for an Interest Only Home Loan
One you have decided that an interest only loan is right for you, here are the next steps you will need to take.
It is important to ensure that the loan value you want to borrow is within your means. If the amount is not realistic when taking into consideration to your income and existing financial obligations, it is likely that your application will be unsuccessful.
To help you find out how much you might be able to borrow, look for an online mortgage calculator and calculate how much you need to pay monthly for an interest only loan.
Make sure that you include additional costs such as home-owners insurance and real estate taxes in your computation. The loan amount should not be higher than 28 percent of your income.
Taking the example above, a person who receives a monthly salary of $6,000 can afford to repay a maximum amount of $1,680 for loan repayment based on the 28 percent rule.
If your gross income does not meet these criteria, it will be necessary to reduce the amount you wish to borrow. An individual’s total borrowings should only be 38 percent of the debt ratio. The debt ratio refers to the total mortgage payment and other debt divided by the total assets of an individual.
Documents You Need
If you are applying for a loan, you will need to prepare these documents:
- Pay slips or any other documents that show your gross income or earnings. The documentation should include the date when you started working for the company as well as your salary details.
- For self-employed individuals, bring tax assessments and full financial statements of your business for the last two years. Also bring financial statements showing the performance of your business for the past three months.
- Bank statements showing receipts of any rental income and/or a copy of the rental lease.
- Bank statements showing three months of income.
- Credit card and store card statements.
- Statements of any existing home loans and other loans in your name.
What Happens When You Can’t Afford To Pay Off The Principal Portion Of The Loan At The End Of The Term?
If you find yourself strapped for cash by the end of the term of your interest only mortgage, you may have the option to extend the term. It is important to plan your finances to make sure you build enough funds to pay off the principal portion of the loan when the term is over. Failure to do so may put your home at risk.
What Are The Usual Terms Of A Home Loan?
Most interest only home loans last for five years. However, some lending facilities offer terms of as long as 10 years.
How Do You Know That The Interest Only Mortgage Is Right For You?
Understanding and determining that the interest only home loan is right for you can be tricky. Before taking out any home loan it is always better to seek advice from professionals.
You need a quality mortgage adviser to help you out. Don’t leave your future to chance, speak to the right person to help you make the best decision.
Make an inquiry now with your friendly Melbourne mortgage broker, Christopher Berry.
Mortgage Broker Melbourne Victoria Australia © 2018 Mortgage Broker Melbourne
Official mortgage broker of www.propertyinvesting.com