As you hunt down houses and chat to lenders, you could bump into interest-only (IO) home loans. They sound nifty and are certainly an alternative to regular mortgages. But are these loans the way to go for you?
Interest-only loans explained
Basically, IO loans come down to less repayments now – usually for about three to five years, depending on your lender – but much more repayments later, when the loan expires. As the name suggests, IO loans see buyers only paying the interest of their borrowed amount (the principal), rather than this same interest plus the principal itself. As long as your IO loan holds strong, your loan balance stays as it is. In comparison, the average mortgage is a principal and interest (PI) loan, wherein you’ll pay off both the principal, plus the required interest on this sum, over about 25-30 years. This is the type of mortgage most buyers are familiar with.
It’s wise to think carefully when considering an IO loan as they have both good and not so good possibilities. These loans can buy you extra money, at a period when you’re often struggling to finding cash for unlooked for details, potential renovations and similar. The same goes for enjoying extra time, particularly if you know your upcoming income may be lower than usual.
Saying this, don’t be fooled by the relief of initially paying lower cash to your lender. When your IO loan expires or ends, your repayments will significantly soar. On this note, an IO loan will also see your overall mortgage extend for far longer than if you take out a PI loan. Why? The principal you’re not paying off still has to be paid back at some point. Remember, all good things must come to an end! Then there’s the fact that some lenders will only give you a high interest rate for IO loans, compared to a PI one. So, make sure you verify this point before you take up an IO option. Also check on potential equity issues as by only paying interest on your home, this price may not comfortably increase.
Preparing for expiration
Three to five years may seem like forever but before signing on the dotted line for an IO loan, consider what your full repayment will be after the loan expires. Many buyers are shocked by what they owe in principal and interest so make sure you know this cost well in advance. You may be planning to enjoy full income in a few years so an IP loan shouldn’t be an issue but it’s always best to prepare for the worst! Interest rates may rise over time too so your repayments may cost even more than you plan for.
As your IO loan expiry date approaches, play it smart and start making higher repayments (if the loan allows it) before you hit this often-dreaded moment. That way, you’re well prepared when you cross the finishing line. Contact your lender and ask exactly when repayments will increase and by how much. While you’re chatting to your lender, ask about the possibilities of extending your IO loan period and if you’ve been unhappy with them for awhile, consider refinancing your loan altogether.
To sum up….
IO loans can be a good idea for some buyers, especially investors. But they can tempt people to purchase a property higher than they can actually afford. As such, bear in mind that IOs will always become PIs one day!