Why interest-only home loans aren’t as cheap as they seem

When it comes to investment properties, I see many clients opt for interest-only loans, with the perception it’s a cheaper option when compared to principal and interest loans. However, often, these loans are a false economy.

In fact, for almost the same monthly payment on an interest-only loan, you could pay off the loan over 30 years on a principal and interest loan.

Just because an interest-only loan looks cheap, it doesn’t mean it is.Credit: Gabriele Charotte

My generation considered a 1 per cent difference in interest rates insignificant when we were paying up to 18 per cent. But now a 1 per cent difference in the interest rate makes about a 15 per cent difference in the amount of interest you are paying.

That 15 per cent can pay off a lot of principal over 30 years. As interest rates reduce, if that 1 per cent difference does not, this point becomes even more relevant.

Let’s assume 7 per cent principal and interest or 8 per cent interest only, on an $800,000 loan. The monthly principal and interest payments over 30 years would be $5322. Interest only is $800,000 multiplied by 8 per cent, then divided by 12, so $5333.

Basically, the same cash flow cost over 30 years whether it is principal and interest or interest only – but at the end of those 30 years, if you had opted for principal and interest the $800,000 loan is paid off! That 1 per cent reduction in interest rate has effectively given you $800,000.

Further, consider that the banks are unlikely to let you stay at interest only for 30 years, and line of credit arrangements attract even higher interest rates.

The numbers are really quite intriguing. For example, if you were to even up the repayment by paying that extra $11 per month off the principal and interest loan, that $3960 over 30 years would reduce the term of the loan by three months, saving you $16,000.

Keep on top of the interest rate you are being charged and review regularly. Taking our example of 7 per cent interest on an $800,000 principal and interest loan over 30 years, the total interest over that period will be $1,116,435.

If you can find a 6 per cent interest rate and still take the loan over 30 years, the repayments drop from $5322 to $4796 per month, and your total interest over 30 years will be $926,968, while you have an extra $526 per month to invest elsewhere.

Alternatively, keep the repayments the same, at $5322, with a 6 per cent interest rate, and you will pay off the loan in 23 years and four months with total interest of only $686,099.

If you still have non-deductible debt on your home you might want to pay that off as soon as possible, so you are looking for anything that will reduce the amount you have to pay on the deductible loan, allowing more to be paid off the non-deductible loan.

The numbers and due diligence are so worth doing. This is the next 30 years of your life! A simple loan calculator like Noel Whittaker’s can do the numbers for you.

Julia Hartman founded BAN TACS Accountants more than 30 years ago and is still passionate about all things tax.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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