One of the decisions you need to make when getting a mortgage for an investment property is whether to pay Principal plus Interest or just Interest Only. And yes, for those who don’t know, you can just pay interest on your mortgage without paying down the principal loan. They are distinct enough for the banks to offer separate sets of Principal & Interest (P&I) loans and Interest-Only loans.
Today, we will explore the differences between these two and hopefully, you will know which is more suitable for your need.
#1 - Interest-Only loans are only available for Investment properties
This is a relatively new development with the banks. Since around 2017, banks started to restrict what purpose an interest-only loan can be taken out for. Property investment is perfectly fine, but if it is for your own home, the banks will have very strict requirements that you need to meet, and even then, they still tend to decline such loans. Unless you have an exceptionally good excuse, such as financial hardship or major life events, it is not worth pursuing an interest-only loan for your own home.
#2 - Interest-Only rate tends to be higher than P&I rate
This is true even for the same investment purpose. One explanation the banks used is that interest-only loans are riskier, so they increase their rates to compensate for this risk. Most banks set interest-only rate about 0.2% or 0.3% higher than their P&I counterpart.
#3 - Interest-Only repayment is typically lower than P&I
This is because with P&I you are paying both interest and principal owing on the loan, while Interest-Only loans require you to pay only the interest, exactly as it sounds.
Let’s look at an example, for a $500,000 loan at 6%, you would need to pay $2,998 per month with P&I. The same loan but with Interest-only will have interest rate of 6.3%, and repayment is $2,625 per month. Interest-Only repayment is $373 (about 12%) lower than P&I every month.
#4 - There is no Interest-Only loan for life
These loans typically last for up to 5 years. After this period, you will need to either seek approval for another Interest-Only term, or go with P&I. While you can maintain Interest-Only payments for quite a while, there will come a time when you no longer meet its criteria and have to revert to P&I payments. This usually happens when interest rates are higher, or you have more debts, or you are older. When Interest-Only is no longer an option, you will need to pay P&I at a much faster pace to catch up.
For our example, let’s say you pay interest only for 5 years at 6.3% and the bank allows you to extend for another 5 years at the same rate. After 10 years and you cannot extend it any longer, you will still have a $500,000 loan reverted to P&I at 6% that needs to be paid in 20 years. Repayment will be $3,582 per month. If you have been paying P&I from the start, your repayment would remain at $2,998 per month.
#5 - You pay more interest overall with Interest-Only loans
Even though your monthly repayment is lower, it is only for a while and none of it goes toward paying down your mortgage. When you start paying P&I, you will still be charged interest as if your loan just started, only this time you have to pay it much quicker. All of these add up and you will pay more interest in the end.
Going back to our example, if you have paid P&I from the beginning, total interest you would have paid over 30 years is $580,000. While if you have paid interest-only for 10 years, and then P&I for 20 years, your total interest after the loan is paid off is $675,000.
#6 - Interest-Only loans reduce your borrowing capacity for the next loan
This may sound counter-intuitive, how can lower repayment reduces your borrowing capacity? This is because of current assessment rules with the banks. For interest-only loans, they look at what you will have to pay when it becomes P&I, not now when it is interest-only. The higher repayment puts you in a worse position, hence lowering borrowing capacity for next loan.
In our example, the banks will consider $3,582 as your current repayment, instead of $2,625. This will ensure that you can cover all of your liabilities even when they revert to the higher repayment.
To sum it up, you can think of Interest-Only loans as a specialised tool for a specific purpose. Paying a lower repayment upfront can be very helpful in many circumstances, but it is a double-edged sword that can be harmful if used incorrectly. To help you with your decision-making, here are a few points of consideration:
Your age: the older you are, the less likely you can qualify for an interest-only loan.
Lower income potential in the coming years: If you are expecting maternity leave, or an extended career break, paying interest-only may be a good option to reduce your financial outgoings until your income picks up again.
Investment strategy: whether you plan to sell quickly or to hold long-term. The longer you hold the property, the more interest you will pay with this type of loan.
Market direction: when prices are going up, you always have the option to sell quickly so minimising your principal payments can be effective. However, if market slows down and selling is slower or less profitable, you may have hold the property for longer and pay more interest than anticipated.
Interest rate direction: when rates are low, it is relatively easy to extend interest-only loans. As rates start going higher, you may no longer qualify and have to go P&I.
I hope this has helped explain what an Interest-Only loan is, and whether you should consider it in your situation. If you have any questions that you wish I had covered, do leave them in the comment section and I will do my best to answer them. Until next time, stay sensible.
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