When I first put in place a home loan 32 years ago all I could think about was how I was going to pay it off and own my own home. The day I made the final repayment was one I’ll always remember. I was free of the bank…until we decided to upgrade but that’s another story. My point is, back then, we weren’t given the option of an interest only repayment.
This article is not about which option suits you, it’s merely an explanation of the relevant facts you should familiarize yourself with before entering into a home loan contract. Why? Well, because ticking the interest only box says you never plan on repaying your home loan. You’re kind of giving up before you start. That’s why some banks charge a little extra for this option and ASIC is now investigating brokers that use the lower repayments as a marketing tool to gain an advantage with unsuspecting borrowers.
A few months ago, Nick and I had a busy evening visiting prospective borrowers in Sydney’s northwest. We saw five clients that night. One of them was a gentleman that had banked with the same bank all his life. We did what we usually do and compared all the loans available to him with his current bank. A few days later we follow up to discover that he’s staying with the same bank. When we inquire as to why he tells us his monthly repayments will be almost $700 cheaper than our cheapest quote. Given the loan amount was for $600,000 this was no mean feat. How could this happen? His banker had focused solely on his client’s cash flow and offered him an interest only loan whereas we had (under instructions from him) showed him principal and interest loan repayment options.
The client was unaware that 5 years from now his home loan balance would be exactly the same and that he would never repay his loan. That’s the thing with interest only (IO) loans for your principal place of residence. The later you start repaying the principal amount of the loan, the more it will cost you. Here’s an example of an IO loan compared to a P&I loan and what the principal is now and what it will be in 5 and 10 years’ time (I’ve left the interest rate the same for comparative purposes) – obviously for the IO loan the principal won’t change:
| Now | After 5 Years | After 10 Years | |
|---|---|---|---|
| Amount Owing | $750,000 | $750,000 | $750,000 |
| Term (Years) | 30 | 30 | 30 |
| Rate | 3.85% | 3.85% | 3.85% |
| Repayment (IO) | $2,406 | $2,406 | $2,406 |
| Repayment (P&I) | $3,516 | $3,516 | $3,516 |
| Future Value (IO) | $750,000 | $750,000 | $750,000 |
| Future Value (P&I) | $750,000 | $676,763 | $588,003 |
| Difference | $0 | $73,237 | $161,997 |
Note, the two most critical factors affecting IO payments when compared to Principal and Interest (P&I) are that the monthly repayments for the IO loan is much lower but at the end of 5 or 10 years you still owe the same. However, with P&I (in the example above) you would’ve reduced your loan just over $73,000 over 5 years and by around $162,000 over 10 years. That’s using the same rate for both types of loans. While some lenders charge a little more, we expect this to change so that all (or most lenders) charge more for IO loans.
So, for those of you that still don’t get how something that you’re paying less for can cost you more what’s the total cost comparison?
| P&I | IO for 5 Years | IO for 10 Years | |
|---|---|---|---|
| Total Cost | $1,265,782 | $1,287,365 | $1,365,498 |
Our experience has been that once someone is used to paying IO, they don’t want to change to P&I. The devil is in the detail. So if you have a hundred grand to waste, then pay IO. We recently refinanced a couple that had been paying IO for 15 years (they just kept changing lenders) but convinced them that in the long run they were better off paying P&I. So if your bank is just telling you about the lower repayments – dig a little deeper. If you’re still dis-satisfied, call a broker that can do those calculations for you and not just one that puts all of your numbers into a model supplied by the lenders.