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

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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.

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