Should you consider an interest only loan?
Few of us are fortunate enough to be able to afford buying a house without taking a home loan. For the rest of us, there are a number of decisions that need to be made when taking a loan to buy property.
Broadly, loans are of two types – table loans and interest only loans. The mechanics are straightforward. The bank or lender offers you the loan amount, and as a guarantee takes a mortgage on the property. This is the guarantee against you not being able to repay the loan by the amounts you have committed to repay and in the frequency you have agreed to repay. The mortgage on the property means that the bank is then able to sell the property to recoup their loan to you, should the above crisis happen.
If you take an interest only loan, your regular repayments are based only on the interest rate charged on the total amount of the loan (called the principal). At the end of the loan period (usually under 10 years), you are expected to repay the principal in full.
As opposed to the above, if you take a table loan, your regular repayments will not only include the interest amount charged but also a small portion of the principal, which is paid over the life of the loan (typically up to 30 years).
As a result, your regular repayment amount will be higher under a table loan versus under an interest only loan. Also, remember the total loan outstanding over the period of the loan will remain the same for an interest only loan and will fall gradually for a table loan.
There are a number of times when interest only loans could be considered in your mix, including when:
- You want to commit to lower payments to start-off, given your income profile
- You want to secure that extra special property that may be affordable only if you went for lower payments (as you will need to take a larger loan)
- You know that you may be holding on to the property only for a short time
- You have investment savvy to identify other higher return opportunities that you can invest your money in
- You have a sizeable equity in the property.
However, much of the above benefits are eroded away if you lack discipline and/or plan properly, including when:
- You forget that at the end of the interest only period (which is shorter relatively) your repayments are going to jump significantly, given that you have a commitment to repay the capital or re-structure your mortgage
- You don’t factor in the reality that over the period of the loan, the interest rates will have moved around and a rise in interest rate will severely impact how much you have to repay
- You end up spending the money you have left over from not paying part of your principal on things other than investments and savings. For e.g., on holidays, entertainment etc.
As you can see, interest only loans are not for everyone – but, if used wisely and in a disciplined fashion, it has a number of benefits. Once you have figured out which route to take – i.e., whether a table loan or an interest only loan, it is critical you ensure you have the best deals on mortgage rates.
You can compare home loan interest rates here within a few minutes and look for the features and terms that best fit your budget.