Most people, whether they are owner occupiers or investors, have to borrow money when purchasing property.
When you are in this situation, one of the most commonly asked questions you will ask yourself is:
“Should I take out a principal and interest or interest only loan?”
For those readers that are new to mortgages and borrowing money, an interest only loan means you are not paying off any principal. If you did this for the term of the loan, you would still owe $360,000. However, if you had a principal and interest loan some of your mortgage repayment would be used to pay off the principal and some would be used to pay the interest. If you did this for the term of the loan, you would not owe anything. Let me illustrate these two loans by using an example.
Let’s assume you want to buy a property for $400,000. The bank will ask for a 10% deposit, which means you will have to borrow $360,000. Let’s also assume that you pay a 7% interest rate for the term of the loan, 30 years and house prices double every 10 years.
Interest Only
Monthly mortgage repayment: $2,100
Total interest paid over 30 years: $756,000
House value: $3,200,000
Outstanding loan: $360,000
Principal and Interest
Monthly mortgage repayment: $2,395.09
Total interest paid over 30 years: $502,232.03
House value: $3,200,000
Outstanding loan: $0
If you decide on an interest only loan, your repayments are $359.09 less per month than if you had a principal and interest loan. This increases your cash flow which means you have extra money to spend or possibly use this money for further investment purposes.
If you decide on a principal and interest loan, your mortgage repayment is higher but you save over $250,000 as your total interest paid over the 30 years is much lower than the interest only option and you have paid off the house.
So what is a property purchaser to do; take out a principal and interest or interest only loan? There is no right or wrong answer as it depends on a number of factors. Most people will have a principal and interest loan for the home they live in but many investors take out interest only loans when purchasing investment property as the extra cash flow can be used to fund further investments.
There are other factors to consider when taking out a loan. My suggestion is that you talk to your lender/mortgage broker and get some proper advice as to which loan is best for you. Make sure that the advice you get is in your best interests!
Written by Peter Koulizos.
Lecturer and author of The Property Professor’s Top Australian Suburbs (John Wiley & Sons).
www.thepropertyprofessor.net.au