Numerous mortgage borrowers shy away from interest only home loans because they fear that they will never make headway with their mortgage and in many ways they are correct in this school of thought. However, interest only loans can help you get the best of both worlds if you know how to make them work for you.
An interest only (OI) loan is where the borrower only repays back the interest on that loan rather than making repayments towards the mortgage (principle). This type of loan is more suitable for property investors who buy real estate for the sole purpose of developing it and selling it on again within shorter periods of time. These loans can be useful for saving money for owner/occupiers too under certain circumstances.
IO loan repayment amounts will always be smaller compared to standard principal and interest (P&I) loans, because you are only obliged to repay the interest and not the mortgage. For example, imagine someone borrows $200,000 in the form of an IO mortgage, where they are required to pay off the interest charged each month at a 7% rate (which is $1,165 per month or $14,000 per annum). The IO option is $250 less per month compared with a standard P&I mortgage which would cost roughly $1,415 per month.
The Advantages of Interest-Only Mortgages
The spare cash that you save each month using an IO mortgage can be used to put aside money into your savings and help build a buffer for other living expenses and emergency funds.
If you become worried that you aren’t paying off your mortgage and only satisfying the debt, there is always the option to pay more per month in order to contribute towards the mortgage. E.g. you could convert your mortgage to an IO loan and make payments of $1,415 per month, although you only need to pay $1,165.
The increased financial flexibility to pay what suits you each month makes these types of loans attractive to customers. This may be the case if you are expecting children or someone loses their job. At which point you could always switch back after the children have left home.
An IO loan offers the opportunity to investors to make it tax deductible and this form of mortgage means each payment can help maximise an investor's tax deductions each year. They may take out an IO loan and rely on the appreciation of the property to pay the principle at the end of the term.
The Disadvantages of an Interest-Only Mortgage
The IO loan is primarily targeted towards property investors and developers which is why they are generally interest only up to 5 years, with some exceptions of up to 10 and 15 years.
If you are taking out a mortgage as an owner intending to live there, then taking advantage of the low interest rates currently available (in comparison to historical rates) is a great way to reduce the size of the principle loan in case the rates rise in the future. If rates do rise in the future you will be paying higher rates on a smaller loan size.
Once the interest only period is over, the mortgage will refer back to a standard P&I loan.