I was speaking with a doctor the other day. This particular doctor was telling me he wanted to pay less in terms of repayments on his loan. He wanted to use the extra money to pay off other business loan.
I suggested an interest only loan. This type of loan is becoming increasingly popular in the Australian market.
An interest only loan is different from a regular loan because as the name suggests, the repayments you make only cover the interest on the loan you take out. It’s a unique type of loan because for the agreed upon period (usually up to 5 years) the borrower only has to pay the interest on the loan they took out. At the end of the period, it falls back to the traditional repayments of both the principal amount and the interest together.
In 2015 $153.8 billion dollars’ worth of interest only loans were taken out, making it one of Australian’s fastest growing loan types. However, like its traditional counterpart, it has both advantages and disadvantages to it.
In terms of advantages there are three major ones:
- Smaller Repayments: Your repayments are smaller at first, which is a plus for those with other high-interest loans to pay off, or those who are looking to buy an investment property or business space.
- Maximised Tax Deductions: It can help maximise tax deductions on investment properties. Interest paid on home loans can be tax deductible, by paying interest only on the property it maximises the deduction for the investor.
- More cash for other things: It can free up cash to put towards other expenses. For businesses, this means that the money that would be spent on paying back the principal amount could be funnelled into operating costs for the business or upgrades on equipment or facilities.
There are also 3 main disadvantages to interest only loans. These are:
- The principal amount doesn’t decrease: So, while you are still making repayments on the property, your debt doesn’t reduce. Many investors who take out interest only loans rely on the value of the property increasing during the loan period and then selling the property off at the end of it to repay the principal amount borrowed. The risk in this strategy is that if the property value doesn’t increase or decreases the mortgage you could be left paying would be worth more than the property itself.
- Overspending: While only paying, interest frees up cash flow it could end up tempting you to spend more than you can afford at the time. Using the extra cash to cover day to day and run of the mill costs instead of paying down other debt could be wasting money and spending more than you can afford.
- More expensive in the long run: Interest only loans can end up more expensive in the long run as you end up making more payments on the loan as a result of the 5-year buffer. This extends the life of the loan taking more time and payments to pay it off.
Interest only loans are an invaluable resource for certain people like investors, but they are also considered one of the riskier type of loans. If you are considering one, ask yourself if the short-term benefits outweigh the long-term ones, and if you will be able to afford the larger payments once the interest-only period ends. If you are unsure, ask your broker for advice and see what they can do for you.