Are you considering switching to an interest-only mortgage payment plan? Anthony Bell shows us the potential pros and pitfalls if we’re looking at this as a short-term solution to release some cash to play with…
by Anthony Bell www.bellpartners.com
Switching to an “interest only loan” can be a good option, but before you decide to go down this path there are a number of red flags to work through to see if it’s right for you.
So what is it and when can it be a good option?
As the name suggests, if you have an “interest only” loan you will only have to pay the actual interest cost (plus any minor transaction costs) on the loan when you make your regular repayments, not a higher figure that includes an amount to repay part of the loan balance itself. This reduction in your repayments has the obvious benefit of freeing up your cash flow – the real question though is what you do with this extra cash.
This additional money can be useful to ease family pressure to cover day to day living expenses or if the cash is needed to help sustain or grow a family business.
If you have other debt that is at a higher interest rate than your home loan, paying down this debt should be a priority. Making interest only payments on your home loan will free up the cash to do this. Credit card debt can attract interest of 18% p.a. or more, making this repayment your number one goal.
As an alternative strategy you should also consider consolidating these higher interest debts into a loan geared against your property – contact you finance broker for details.
If your loan is on an investment property, it is often beneficial to have an interest only loan as there is little point paying down your debt and reducing your tax deductible interest costs on your investment property loan if you can use the extra cash flow to pay down other non-deductible debt such as on your home or credit cards.
What are the traps for the unwary?
Before you consider whether to go through the motions of converting your loan, you have to consider carefully how you will use the extra cash. Financial discipline is the key. One of the great benefits of a standard home loan is the forced financial discipline of having to repay the loan and not just the interest – a forced saving if you will. For most people, having your principal and interest loan repayments regularly coming out of your account automatically means “if it’s not there to spend, you won’t spend it”.
If you do go down the interest only path, it is really important that the extra cash flow is applied to make you financially better off overall by paying down other higher interest debt or non-tax deductible debt, covering essential bills that you cannot otherwise cover or growing your business and not “wasted” on things you’d like to have rather than actually need.
Having assessed that it is still the right thing to do, you then have to consider the steps and costs you need to take to switch.
You will generally have to be on a variable rate to switch your loan to interest to interest only. If you are on a fixed rate, large break fees may apply.
Most banks make the assumption that a request to switch your repayments from “principal and interest” to “interest only” means you may be undergoing some sort of financial hardship. Your bank will want to conduct a full new serviceability assessment on your current financial situation where they will look at your ability to repay the loan. They may even revalue your property to ensure you have sufficient equity in the property.
It is virtually as if you are applying for a new loan.
You therefore need to be certain when applying for the switch that your personal position hasn’t weakened since you last applied for finance as the bank may not only reject your switch application but also question your ability to continue with your existing loan. They may have the right to call up your whole loan.
You also need to be careful that the current valuation on the property is as high if not higher than when you originally applied for finance. If it is lower, the bank may reject your application if the loan amount is too high compared to the value of the property.
By switching you are allowing the bank to undertake whatever checks they deem fit to access your current financial situation.
Interest only rates are generally for the first 5 years of a 25 or 30 year term. This can often be extended at the end of the 5 years provided you have a good repayment history.
You can still make principal repayments if your cash flow allows provided the loan is on a variable interest rate and not a fixed rate. Most fixed rate loans only allow you to pay up to $10,000 p.a. additional to your current repayments.
So is switching to an interest only loan the way to go?
The short answer is it can be, provided that the extra cash is put to good use to improve your overall financial situation and remember that your bank will need to review your current circumstances before approving the switch.
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