Interest-only loans are pretty much what they sound like: you borrow money and your regular repayments only cover the interest costs. The outstanding loan amount remains constant, though it must eventually be repaid in full.
This is in contrast to principal and interest (P&I) loans, where part of each payment comprises interest with the remainder paying down the overall amount of the loan. P&I loans are usually fully repaid within an initial set timeframe.
Interest-only loans are not generally provided for long terms. For instance, a homebuyer or investor takes out a 25 or 30-year mortgage and repays only interest for the first five or ten years, after which the property is sold and the loan paid out in full, or it reverts to a P&I loan for the remainder of the term.
A major attraction of interest-only loans is that initially the monthly repayments are lower. For example, take out a standard P&I loan for $300,000 over 25 years at an interest rate of 5% per annum and your monthly repayments will be $1,754. On an interest-only basis for the first ten years, repayments would be just $1,250 per month.
The crunch comes when the loan reverts to a P&I basis. Now with just 15 years to pay off the principal, repayments jump to $2,372 per month. And as the amount owing on the loan has been higher for longer, the total interest costs will be more. Opting for a ten-year interest-only period on a 25-year loan will end up costing $50,897 more in interest than for a standard P&I loan. Any rise in interest rates during the term of the loan will magnify this extra cost.
Interest-only loans may leave you with less equity in your home. If property prices fall, this increases the risk that you could owe more than the property is worth.
There are some situations in which an interest-only loan may be a sensible way to borrow.
A typical example is bridging finance, such as when you have bought a new home but need some time to sell your current property. If you are confident the loan period will be short, it may be attractive to opt for the lower repayments.
These loans are popular with investors seeking to maximise tax deductions on investment loans and who wish to maintain a given level of gearing within their investment portfolio. It’s a similar story for businesses. If it’s possible to borrow at 5% interest and achieve a consistent return on investment of 10%, then it doesn’t make much sense to repay any principal.
But in each of these cases borrowers need to know what they are getting into. Any debt increases financial risk, and interest-only loans create a higher level of debt than a comparable P&I loan.
Choosing between the two may not be as simple as one or the other. Interest-only loans require a prior credit assessment to ensure the borrower will be able to repay the loan without “substantial hardship” when the lump sum becomes payable at the end of the term.
For this reason, always seek advice from a licensed professional on (07) 3040 4840 to ensure you make the right choice – not just for the present, but the future.
The advice on this site may not be suitable to you because it contains general information that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on this information. Please also refer to our general advice warning under contact us tab on our website. The article is based on information available at the time of writing only and therefore care should be taken as to the accuracy of the content.
Image courtesy of [ Vichaya Kiatying-Angsulee.] at FreeDigitalPhotos.net