An interest only loan can seem like a great idea at the time – but there are plenty of risks involved in buying a property with a loan that fails to pay off any principal.
Interest only loans are popular with property investors, as they allow you to minimise your mortgage repayments in the short-term, while your property asset hopefully grows in value in the long term.
Interest only loand and mortgages are exactly what they sound like: they require the borrower to repay only the interest on the loan, rather than a standard principal and interest loan.
Let’s say you own a property worth $360,000, with a $300,000 interest only loan at 7% with a 30 year loan term. Your repayments would be just $404 per week. On the other hand, with a standard principal and interest (P & I) loan, the weekly repayment would shoot up to $460.
Clearly, the immediate cost savings are significant, and they can help to ease the financial pressure in the short term – but it comes at a price.
The main disadvantage is that you’re making no headway on your overall mortgage.
In the above scenario after five years have passed with an interest only loan, you’ll still owe $300,000 on the property if you take out an interest only loan. With a standard P & I mortgage, after five years you would have shaved a good $17,605.23 off the balance of your home loan.
Essentially, this means that you will not have the benefit of gaining equity in your home, even though you are making mortgage payments every month.
Investors work around this by predicting that in five years time, the value of the property will have increased anyway. They hope that their $360,000 property will be worth at least $400,000, so they will have equity in the property without having paid a single cent off the principal.